New Opportunities in Emerging Countries

As the uncertainty about short-term credit markets and medium-term economic growth projections has been weighing down on the financial markets in the developed world, investors search for new growth and diversification opportunities has been rapidly shifting to the 'Blue Chip' emerging economies - the BRICs (Brazil, Russia, India and China). According to the latest figures from Morgan Stanley, total market capitalization of BRIC economies currently stands at around 1.18 trillion. This pales in comparison with the US markets, which enjoy total market capitalization of 9.65 trillion. However, since the beginning of this summer credit crisis, investors fleeing the turbulent waters of the established financial centres in Europe and the US have been pumping funds into the BRICs and across a wider range of emerging economies in general. Since the end of August, the emerging markets equity funds swell by some 23.2 billion in new cash. In the last week of October alone, according to the report in the US-based Financial News, global emerging markets equity funds gained ca 3.94 billion, marking the highest weekly figure ever recorded. Why the economies of Brazil, Russia India and China are becoming important: There are several important structural reasons as to why the BRICs are becoming increasingly more important as financial assets destinations for international investors. First, there is a "catching-up-with-the-Joneses" argument that suggests that recent inflows of funds into the BRIC economies follows on the heels of an earlier surge of private equity flows. A classical financial markets growth paradigm suggests that the flows of funding to new and/or rapidly growing markets can be divided into three main stages. The first stage is characterized by increased investment from the private equity funds and M&A activities. The second stage of the bull markets is usually associated with the investment funds following after the private equity money. Finally, in the last and longest bull market stage, individual investors move into the markets. Between January and August 2007, some 20 billion in private equity funds moved into the emerging markets, suggesting that by the year end some 48-50 billion private equity investments will be allocated in the emerging economies. The vast share of these funds is flowing into the BRICs. In the public financial markets, M&A activities in BRIC economies reached the highest three-month volume on record in Q3 2007 - 82 billion. The total January-through-September volume of transactions backed by private investors breached 150 billion, up 50% from the same period in 2006, as reported by Dealogic.com - financial analysis services provider. Of these, some 117 billion is attributable to BRICs - up 132 percent on the same period in 2006. This suggests that the first stage of the new bull markets in the BRIC economies is well underway and that one should expect significant uptake in the inflow of managed funds into these markets as well. Second, there is an argument that the BRIC economies have much more upside potential for future growth than their European and US counterparts. In part, this argument is about the overall markets growth capacity. In the US, the ratio of total markets capitalization to GDP stands at around 1.1:1 or almost an inverse of the 1:1.12 average ratio for the rest of developed countries. In China the same ratio is 5:1, with the mainland equity markets capturing only 20 percent of the overall GDP of some 2.24 trillion economy. In Brazil, the country's market capitalization stands at 35% of its GDP - a ratio of market capitalization to GDP of 1:2.9 or more than three times lower than that in the US. This ratio was significantly improved by the 2.55 billion strong flotation of Bovespa - the holding company for the Brazilian stock exchange - this October. Perhaps more important are the longer-term growth trends in the BRIC economies' incomes. One recent study from Goldman Sachs has projected that the combined GDP of the BRIC countries will exceed that of the current G6 (United States, Japan, Germany, France, United Kingdom, and Italy) before the year 2050. However, more pertinent is the short-term process by which the current growth in the world's economies translates into financial markets performance. According to the latest Grant Thornton International Super Growth Index 2007 - the index that captures the trends in rapidly growing companies around the world - the BRIC countries led the world in terms of overall growth potential for their companies in 2004-2006. The 2007 figures, compiled before the realisation of the current financial crisis in the US and Europe, put the BRICs at a parity with the world-wide average. However, the growth potential realized by the companies in any given year translates with a lag of 1-2 years into the financial markets performance in the majority of developing countries. The reason for this is that in countries with less advanced financial markets, privately held firms tend to often outperform, on average, publicly listed companies. As these companies gain momentum, more and more of them go public, with their record of growth translating into lagged markets performance. Big EU economies also fared well, but not as well as in 2006. The UK gained 10.42% (down from 32.47% growth in 2006), Germany was up 24.04% (also down from 38.23% in 2006), and France advanced 14.56% after rising 37.60% last year. These results were not reflective of the poor French and German economies performance in the end of Q2 and the beginning of Q3 2007. Impact of current credit market upheaval: Another important consideration not reflected in the table above is the expected slowdown in overall economic performance in the countries impacted by the current credit markets upheaval. This slowdown is currently forecasted to be in the region of 0.3-0.5 percentage points of overall global GDP growth rate, but is not expected to feed through into the BRIC economies. Thus, the parity in supergrowth index reflected in the table above for 2007 is likely to translate into a strong advantage to the BRIC economies over and above the world average. Amidst all this optimism, it is important to note, that while the emerging markets may represent a very strong growth opportunity, their performance is susceptible to sharp corrections and dramatic downturns in response to a wide range of endogenous and exogenous shocks. For example, in December 1994 Mexican peso devaluation led a general run on the emerging economies' financial markets, which declined by some 24 percent in a very short period of time. In another global wave of market crises, Russian debt default on August 17, 1998 has wiped out 19 percent of the emerging markets capitalization around the world. Within 6 months following Thailand's decision to devalue its currency in July 1997, the country financial markets suffered a 37 percent loss. In addition, based on some broader indices of emerging markets performance, since September 2001 there has been at least five major (magnitude of 10 percent or more) markets corrections. Despite, and often because of, the overall stellar performance of the BRIC markets this year, some analysts and high profile investors, such as Warren Buffett and Alan Greenspan, believe that some of the emerging markets are becoming overvalued. Other observers believe that the markets in BRIC economies have a long way to go before reaching their zenith. Between 2001 and today, the MSCI China index, which includes shares that can be held by foreigners, has jumped 501 percent, but earnings in Chinese companies that can be held by the foreigners have risen at approximately 33% on average over the same period, yielding gains of roughly 554 percent over the same time, according to the data from Morgan Stanley. Russian Micex index increased by 780 percent, while profits in its member companies have grown by around 430 percent, suggesting underlying earnings growth of around 690-900 percent. Similarly healthy price to earnings and profits to earnings ratios hold for India's Sensex. It is important to recognize that with rapidly dissipating prospects for significant economic growth in Europe, Japan, the US and elsewhere in the developed world, emerging markets provide investors with an opportunity for higher-risk and higher-return gamble. These markets are not for the faint-hearted or short-term investors and their inherent complexities highlight the need for in-depth understanding of their fundamentals, companies research and timely management - all hard to achieve for an individual retail investor. For investment advice, signup to the RaboDirect eZine or visit the RaboDirect Investor Centre for investment articles. Financial directory