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I n sig h ts
Emerging Markets
Understanding the risks
October 2010
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Emerging markets offer compelling long-term return
potential, but continue to present risks that every
investor should understand.
In this paper, Richard Titherington, CIO of the Emerging Markets Equity Team at
J.P. Morgan Asset Management, discusses the risks inherent to emerging markets and
looks at the effect they have had on economic and investment performance. He also
explains why globalisation and urbanisation mean that, for long-term investors who are
aware of the risks, there is considerable reason for optimism about emerging markets.
I believe in the long-term outperformance of emerging market equities as an asset
class: if I didn’t, I wouldn’t be working as head of J.P. Morgan Asset Management’s
Emerging Markets Equity team. However, it is important for us and our clients to
understand the risks inherent in the asset class.
The Fundamentals Driving Emerging Market Equities
First, it is worth restating the two fundamentals driving the development of the
emerging market asset class.
The first is the rebalancing of the world economy from the extreme of concentration
of economic power typified by the creation of the G7 (the group of seven industrialised nations) in 1976, which meant that by the end of the Cold War in the early 1990s
the developed world of North America, western Europe, Japan and Australasia,
approximately 12% of the world’s population, represented 77% of global GDP. It is
this extreme degree of economic imbalance that is unusual, not the more balanced
world we are moving back towards.
Exhibit 1: The really big picture
Emerging markets’ rising share of global GDP
Author
Emerging markets (%)
North America (%)
Developed Asia (%)
1.8 3.4
Europe (%)
21.2
19.1
28.8
33.6
5.5
48.1
11.6
66.0
19.1
41.8
Richard Titherington
Managing Director
Chief Investment Officer
Head of the Emerging Markets Equity Team
Fo r In st it ut ion a l Use Only
1820
1913
Today
Source: J.P. Morgan Asset Management, Angus Maddeson 2001, IMF as at end 2009, GDP in PPP terms
Emerging Markets
Exhibit 3: Ten largest emerging markets
Revolution and inflation
The equivalent of
half the population of
Europe moving from the
countryside to the city.
The second key driver is urbanisation—the continuing move of
population from the countryside to cities—which drives both
productivity and consumption. Approximately 50% of the
world’s 6.8 billion people currently live in urban areas.
However, more than 95% of the population of developed
countries are already based in urban areas. In consequence,
close to 100% of the productivity and consumption growth
derived from urbanisation lies in the emerging world, sustaining faster economic growth.
Exhibit 2: Urbanisation—the big move
350m people forecast to move from rural to urban locations
between 2010 and 2015
Emerging regions—rural population
Emerging regions—urban population
Total change from prior five-year period—urban population
500
450
90
80
Percent
60
300
250
200
50
40
30
150
100
20
10
Million people
400
350
70
50
0
0
1950
1970
1990
2010
2030
2050
Proportion of the
MSCI All-Countries
World Index (%)
Revolution
Inflation
China
2.47
1911, 1937–1949
1990–1995
Brazil
2.14
Korea
1.80
1910, 1945, 1950–1953
Taiwan
1.45
1911, 1949
India
1.08
1947
Russia
0.84
1917–1922, 1991
Mexico
0.57
1910
Malaysia
0.41
1963–1965
Indonesia
0.31
1945–1949
1998
Chile
0.24
1973
1970–1975
Turkey
0.24
1918–1923
1973–2004
Thailand
0.22
Total
11.76
1979–1993
1998
1980–1988
1998
Source: MSCI, World Bank, IMF, CIA World Factbook, September 2010.
The economic consequences of political revolution are clear,
with the Russian and Chinese examples of the twentieth century
not requiring further elaboration. Many countries in the emerging world have witnessed less well known but equally damaging
political upheavals, which make political and legal institutions
less reliable and predictable than in the developed world.
The impact of inflation is less obvious but more pernicious in
preventing development and especially in perpetuating poverty. Over the last 100 years, Brazil has grown on average at
4.9% in real terms. This is considerably better than the USA,
which grew at 3.5% over the same period.
Source: World Bank Data. Data as at January 2008. For illustrative purposes only.
Strategic Risks to Monitor
Having described the key positive drivers, let us look at the
risks, and specifically at why many of the emerging nations of
100 years ago are still emerging today. There are two key reasons: revolution and inflation. The chart below lists the ten
largest emerging markets and highlights their experience with
these two destructive phenomena.
2 | Emerging Markets: Understanding the risk
However, Brazil remains an emerging market, while the USA
is the world’s leading economy. Unlike most of the top ten
emerging market countries, Brazil, despite periods of military
rule, has not suffered from political revolutions, partition or
war. Consequently, it should be a candidate for graduation
from emerging to developed status.
Therefore the two strategic risks that we need to understand
and monitor are political upheaval, which leads to the appropriation of assets via revolution as in Russia, China, Turkey, Egypt,
Chile, Cuba, Iran, Algeria and Vietnam, among others, and
inflation, which destroys the real value of assets, as seen in
Argentina, Brazil, Zimbabwe, Russia and Indonesia. Political risk
need not be as dramatic as some of the revolutionary examples
given, but may involve an undermining of the rule of law and a
pervasive culture of bureaucratic and corporate corruption that
siphons wealth from shareholders to domestic power brokers.
As such, we should broaden our monitoring of political risk to
governance in general rather than just revolution.
100
90
80
70
Percent
60
50
40
30
20
10
0
1949 1952 1955 1958
1961
1964 1967 1970 1973 1976 1979
Source: J.P. Morgan Asset Management.
Exhibit 5: Brazil inflation 1979–1994
3,000
2,500
2,000
Percent
Inflation increases inequality, impoverishing the majority of
the population. It also undermines currency values, explaining
why for most of the last 100 years emerging market currencies have been weak against G7 currencies. In consequence,
the biggest financial risk we face as investors in emerging
markets is a return to an environment of fixed exchange rates
and high and rising inflation. We expect average inflation in
the emerging world to be 5.5% over the next five years, based
on our internal macroeconomic work. If that assumption is
correct then, except for individual countries such as
Venezuela, the inflation risk in emerging markets is low and
on a completely different scale to that experienced in the
period from 1970 to 2000.
Exhibit 4: Brazil inflation 1949–1979
1,500
1,000
500
0
1979
1982
1985
1988
1991
1994
Source: J.P. Morgan Asset Management.
Exhibit 6: Brazil inflation 1994–2009
30
25
20
15
Percent
The reason that Brazil has not emerged is inflation. From 1958
to 1968 and again from 1975 to 1994, Brazil suffered from
high and even hyper inflation. In only 12 of the last 65 years
has inflation been below 10%, and seven of those years have
come in the last eight years. It is this change from high to low
inflation that has allowed the Brazilian market to return 16%
per annum since 1995: twice the return per annum of U.S.
equities over the same period.
10
5
0
-5
1995
1997
1999
2001
2003
2005
2007
2009
Source: J.P. Morgan Asset Management.
J.P. Morgan Asset Management | 3
Emerging Markets
Tactical Issues
Asset multiples are hovering near long-term averages;
earnings multiples have fallen back below average
Alongside the two strategic risks are the two tactical issues
that should inform any equity investment, emerging or developed: earnings and valuation.
Exhibits 9: Valuations
GEM price to book: 1993 to August 2010t 2 0 1 0
Emerging market equities look cheap relative to emerging
market debt.
MSCI EM
4.0
1,400
MSCI EM long-term average P/B
MSCI EM P/B (RHS)
3.5
1,200
3.0
1,000
2.5
800
2.0
EM bond yields 1
600
1.5
EM equity yields (forward) (E/P)
400
1.0
200
0.5
0
0.0
Exhibit 7: Comparing emerging market equity and bond yields
Emerging market earnings and bond yields, 1991–August 2010
20
1,600
15
Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
10
Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end
August 2010.
5
0
Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
Re-weighted bond yields with equity weightings to make these two
yields comparable.
1
Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end
August 2010.
Exhibits 10: Valuations
GEM price to forward earnings: 1993 to August 2010
25
MSCI EM Fwd PE
23
Rolling Average
21
+/- 1 sd
19
17
15
13
11
9
7
2010
2009
2007
2008
2005
2006
2003
2004
2001
2002
1999
2000
1997
1998
1995
1996
1993
1994
1991
1992
5
1990
Over the last ten years, emerging market debt has re-rated,
reflecting a dramatic improvement in credit quality as the
asset class approaches investment grade. Equities, in contrast,
trade at levels similar to those of a decade ago, meaning
emerging market equities currently appear cheap against
emerging market debt.
Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end
August 2010.
Exhibit 8: Comparing emerging market equity and bond yields
Emerging market equities relative to debt, 1991–August 2010
On an earnings and asset basis, emerging market equities also
appear to be trading close to long-term averages.
8
6
4
The great difference between bonds and equities is that the
former trade on perceptions of solvency, the latter on perceptions of future profitability. Valuation is therefore not a concern on a tactical basis as long as market expectations for
earnings and dividend growth are not unrealistic.
2
0
-2
-4
-6
-8
Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end
August 2010.
4 | Emerging Markets: Understanding the risk
2010
2009
2007
2008
2005
2006
2003
2004
2001
2002
1999
2000
1997
1998
1995
1996
1993
1994
1991
1992
1990
-10
Exhibit 12: Long term dividend growth tested by crisis (% p.a.)
50
Emerging market dividend growth
40
30
20
Percent
Following the cyclical collapse of 2008, earnings have grown
very strongly, with the market expecting earnings growth of
over 30% in 2010. More important for future returns is the
long-term outlook for earnings per share, which is the return
enjoyed by shareholders rather than the GDP growth that
most commentators focus on. The Emerging Markets Equity
Team at J.P. Morgan Asset Management currently expects
average earnings per share growth for the companies we
cover to be over 15% per annum for the next five years. If
this expectation is right then the combination of earnings per
share growth at twice the global level, modest currency appreciation and a current dividend yield of 2.5% (likely to grow at
12% per annum) should give investors an attractive return
from these levels over the next five years.
10
0
-10
-20
-30
1992
1995
1998
2001
2004
2007
2010E
Source: MSCI, IBES, Morgan Stanley as at May 2010, GEM universe. E = MS estimate.
Exhibit 13 – Dividend growth of key sectors (% p.a.)
Exhibit 11: GEM earnings per share growth
100
90
2006
80
29.9%
70
USD per share
60
0.2%
50
Dons
Disc
Cons
Staples
Financials
Info
Tech Telecoms
2.2
39.7
11.3
13.1
19.3
2007
5.5
16.6
33.4
35.0
47.5
2008
-12.6
10.0
5.6
27.4
-3.6
2009E
16.4
-0.9
-3.3
-33.9
9.0
40
2010E
14.9
15.0
21.1
14.0
17.2
30
2011E
15.0
16.5
26.6
27.8
0.6
20
Source: UBS as at 28 February 2010.
10
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
0
Source: MSCI, J.P. Morgan Asset Management, 2010/11 J.P. Morgan Asset
Management estimates.
J.P. Morgan Asset Management | 5
Emerging markets
Conclusion
Emerging markets offer a combination of:
The emerging markets story is by no means without risk,
including the strategic risks of governance and inflation and
tactical risks around earnings growth and valuation. Our current view on these risks is summarised in the table below.
STRATEG I C
• Attractive growth and dividends
• Maturing growth and rising dividends
Four key sectors
• Consumer (discretionary and staples)
• Financials
Governance risk
Infl ation
Low at the national level
among the larger countries.
Low by historical standards
but cyclical pressure
is upwards.
Ever present at the stock level,
although rising average
ROE suggests a positive trend.
Currency flexibility and
economic orthodoxy are key
to continued success.
Valuation
Earnings
In line with historic averages,
although high relative
to developed markets.
A strong cyclical recovery is
being followed by robust
secular growth.
Wide company and sector
variance makes stock
selection crucial.
Reduced dependence on G7
trade gives greater confidence
in the sustainability of EPS and
DPS growth rates.
TACT I CAL
However, for investors who are comfortable with these risks,
we believe there is considerable reason for optimism around
emerging markets, driven by global rebalancing and by the
long-term urbanisation trend, which is spurring dramatic
improvements in productivity and consumption.
jpmorgan.com/institutional
• Information technology
• Telecommunication services
Author
Richard Titherington, Managing Director, is the Chief Investment
Officer and Head of the Emerging Markets Equity Team. An
employee since 1986, Richard transferred to the Pacific Regional
Group in 1994. He was appointed as a managing director in April
2001 and appointed head of the global emerging markets business in December 2001. Prior to 1994 Richard was a US and international pension fund manager, working in the UK until he transferred to Hong Kong in 1992. Before joining the firm, Richard
spent two years as an analyst with UKPI in London. Richard
obtained an M.A. in politics, philosophy and economics from
Oxford University.
J.P. Morgan Asset Management | 7
Emerging markets
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