Emerging Markets Weekly

The message was right but the timing was all wrong when the IMF released an update to its World Economic Outlook last week, announcing that “risk appetite has returned” just as global financial markets were choking on the olive pit of Greek government finances.

Market sentiment shifted over the past week from hope to worry with particular focus on policy tightening in China and the prospects of sovereign default in Greece. The latter issue looks real and intractable with Greece getting knocked out of the European Monetary Union a distinct possibility within the next two years. Policy tightening in China to curb runaway loan growth is a buying opportunity however.

Investors are fretting that as Beijing reins in its bankers from handing out loans as freely as advice that China’s economy will come crashing down. Speaking of advice, Confucius said that, “He who will not economize will have to agonize,” and a little prudence in lending is no bad thing.

Investors are missing the fact that Beijing is simply taking its foot off the accelerator rather than hammering on the brakes. They are still planning to extend nearly twice as many loans in 2010 (in value) as in 2008. And turning back to the IMF update, the global economy is expected to grow 3.9% in 2010 and 4.3% in 2011, a two speed recovery to be sure with emerging economies in the fast lane growing 6% this year and 6.3% in 2011 according to IMF estimates. The advanced economies will see growth of only 2.1% this year and 2.4% in 2011. China is expected to grow 10% in 2010 and 9.7% in 2011.

The MSCI China Index and the Hang Seng Index in Hong Kong have corrected 10% since January 11th setting up a buying opportunity for the next leg of the bull market.

Emerging Markets Weekly

It may be decades before incomes in emerging markets approach developed market levels, yet it seems clear that the sheer size of these populations means that consumer markets are already very powerful forces in many emerging markets.

It is astounding to learn that there were only 6.5 million mobile phone subscribers in India in 2002. The market simply exploded over the past decade as incomes rose and credit became widely available. Currently India boasts more than 500 million cellular subscribers according to the Telecom Regulatory Authority of India.

In China, retail sales rose nearly 17% in 2009 in real terms, up from roughly 15% in 2008. China now boasts an auto market that surpassed the United States in volume making it the biggest market in the world.

Of course we are at a very early stage of development of these markets given the fact that per capita incomes in the emerging markets are a fraction of incomes in developed markets. That is why, China’s auto market is projected to grow to double the size of the U.S. market in just ten years according to Goldman Sachs and India’s cellular market will likely double in only five years time according to the Telecom Regulatory Authority of India.

Gross national income per capita for Brazil, Russia, India and China was $5910, $7560, $950, $2360, respectively in 2007 according to the World Bank; low by our standards. As incomes grow over the next two decades, these consumer markets will eclipse markets in the developed world.

Companies have recognized this trend and many are thankful for their emerging market exposure over the past year given the weak state of consumer markets in the United States, Europe and Japan. For example, GM saw sales growth of 66% in China in 2009 to 1.8 million units versus roughly 1.9 million units in the U.S. in the first months of 2009. This is a trend that is playing out in Emerging Markets with new first time consumers!

Emerging Markets Weekly

A quick look at valuation in emerging markets reveals that the BRIC countries are no longer trading at the discounts to long term averages that they were trading at last year at the height of the financial crisis. The chart below shows the trailing P/E ratio for the four BRIC markets revealing that Russia appears to offer the best value and that neither India nor China are anywhere near the high points reached prior to the onset of the global credit crisis.

One way to look at the rising P/E ratios is that the market is discounting a strong rebound in economic growth in 2010. In India for example, analysts are expecting a 24% rise in earnings for the fiscal year ending March 2010. If these earnings materialize as expected over the course of the year, there is every reason to believe the market could move higher because valuations would otherwise recede to their long-term average.

Given the similarities between valuations in emerging markets and developed market on a trailing P/E basis, it would seem obvious that the higher growth prospects in the EM make these markets a better bet.