Emerging Markets Weekly

At the start of the year, in the midst of the financial crisis, we were quick to point out the extremely low valuations in emerging markets and the once in a lifetime opportunity for investors to buy in to multi-year growth stories on the cheap.

After a dramatic recovery and phenomenal gains over the past year, the world’s stock markets no longer appear cheap—with the exception of Russia for one. Back in February, Russia’s stock market was phenomenally cheap. Yet even after 70% plus gains this year to date, Russia’s stock market remains a buying opportunity for investors with suitably long time horizons.

The MSCI Russia Index is still undervalued based on historical valuation measures and Russia’s economy is recovering after a very difficult year. The index trades at a price earnings ratio of roughly 7, roughly half its average valuation based on data on record dating back to 1996.

Russia’s economy will grow roughly 3% next year after contracting more than an estimated 8% in 2009. Retail sales and investment are weak, but a rebound in in oil prices, economic recovery in the developed world, and softer inflation will allow Russia’s economy to pull out of economic decline and recover. The country boasts low levels of public debt and high foreign exchange reserves that have allowed the central bank to stabilize the currency.

Emerging Markets Weekly

The long term growth potential of India’s market is at times questioned by the high level of government indebtedness in contrast to, say, China’s low level of government debt. At 80% of GDP, India’s high level of indebtedness is a potential drag on growth in the near term and calls for fiscal consolidation now the economy has recovered. The general government budget deficit including off balance sheet items such as subsidies on fertilizer and oil consumption exceeds 10% of GDP. Fortunately, India is in the envious position of having a very high potential rate of GDP growth that will allow it to stabilize its debt more easily than developed nations.

For example, as long as the economy can grow 8% a year over the long term, the debt to GDP is manageable because the rate of growth of the GDP will exceed the growth rate of debt caused by interest payments. Assuming real interest payments on debt of 3% per annum, the government could run a fiscal deficit in excess of interest rates (primary deficit) of 5% to stabilize the debt to GDP ratio. Moreover, the government has long term plans to reduce the national debt by selling off state assets worth an estimated 30% of GDP. If that transpires, which will undoubtedly happen slowly, interest payments on debt will fall.

As India’s economy recovers this year, its economy is expected to grow between 6% to 7%, weaker than recently expected due to a poor monsoon. Investors need to keep a watchful eye on India’s ability to return to its long term potential rate of growth of 8% of GDP. The sooner that the economy recovers and output rises, government finances will recover more quickly and government debt will be stabilized.

Emerging Markets Weekly

Despite concerns in the media that China is about to kill off its economic recovery with tighter monetary policy, the opposite appears to be true. Policymakers appear determined to ensure that China achieves 8% economic growth that is believed to be their unofficial growth target. The economy rebounded in the second quarter to year on year growth of 7.9% and appears likely to exceed that number in the third quarter of this year.

Bank credit is expanding at a 30% year-on-year pace since March 2009, fuelling a tremendous expansion in investment associated with the US$586-billion stimulus plan that was unveiled at the start of the year. The focus of the plan is on infrastructure spending, and it is proceeding according to plan judging by the rollout of projects including rail expansion, airport development, etc. It is evident in the data on fixed asset investment-- up 33% over the year to August.

The government budget deficit of 4.5% for 2009 and net debt of 20% of GDP suggests that the government is well within its limits to boost output this year and next. Investors should bear in mind that the stimulus spending will roll out over the current year and next, so there is plenty more ammunition to carry China’s economy forward to 2011 in expectation of a global economic rebound.

Inflation continues to print negative in China, down 1.2% on an annual rate in August. Expect inflation to begin rising by the start of 2010 as higher oil and food prices start to hit headline numbers. Given the massive loan and money growth in China, we will look to China as one of the first place to see interest rate hikes in the first half of 2010. Nevertheless, risks of a double-dip recession are not a concern for China.

China data for August (year-on-year %):

• CPI: -1.2%
• PPI: -7.9%
• Fixed Asset Investment: 33.0%
• Retail Sales: 15.4%
• M2: 28.5%

Emerging Markets Weekly

Even with a headwind of a high savings rate, the brute force of 1.3-billion people spending even a little more money thanks to rising incomes is propelling China’s consumer market forward. Savings may be falling as a percentage of total output, but incomes are rising making the consumer market in China an unstoppable force that will see urban consumer spending grow five-fold between 2006 and 2025 to US$2.3-trillion according to a report by McKinsey Global Institute (MGI), catapulting China’s consumer market to the third spot globally.

A middle class is taking shape in China-- accounting for roughly one-third of the population today from virtually nothing in 1990 and set to rise to 70% of the population by 2020 according to MGI. At US$3000 in annual income, the threshold for entering the middle class may sound despairingly low by our standards, but it is the point in the developing world where households start buying non-discretionary items beyond food and housing, bearing in mind that the cost of goods is far lower in emerging markets such as China.

Look no further than the mobile phone industry to capture the imagination of the potential for China’s domestic demand. Each month, the mobile phone industry lifts its net and snags an additional 10-million subscribers or so to add to the 650-million people already with mobile phones in China.

At the high end of middle class incomes, car purchases will surely be a major focus of status-hungry consumers. China now has the second largest highway network in the world and leapfrogged the United States to the position of number one car market in the world this year. Given that the auto market is in its infancy, the prospects for car companies over the next decade have auto executives in rapture.

Domestic companies have two natural advantages over foreign competitors: cultural knowledge and established distribution networks; many also benefit from government regulation. Foreign multinationals may have initial success in the four tier one cities (Shenzen, Shanghai, Beijing, and Guangzhou) in China where they are “out-marketing” the competition says Jonathan Chajet, Managing Director for Interbrand China, but they are finding that a great deal of spending comes from the 37 tier two cities and the 136 tier 3 cities with populations greater than 1-million inhabitants. These tier 3 cities represent more than half of all disposable income in China, according to MGI.

It is astounding to think that China has the largest auto market in the world when only 0.5% of the population owns a car in contrast to the United States where 80% of the population owns a vehicle. It is the same story for so many goods and services in China. The growth potential is astounding.

To read the full story at National Post click here:
http://www.nationalpost.com/story.html?id=1963896