sshatipoglu@beri.com

EMERGING MARKET TRICKERY:

Caution is Warranted

Enticing Outlook   A growing portion of investment capital was channeled to emerging markets in 2006, and for good reasons.  Net private capital exceeded US$500 billion, and is expected to be above US$475 billion in 2007.  U.S. mutual funds allocated 6.81% of assets to emerging markets in 2006, compared to 0.42% six years earlier.  These markets have always peaked the interest of the portfolio investor willing to diversify holdings and take risks in uncharted territories, but the recent sustained increase in inflows is based on encouraging economic news.  During the past few years, macroeconomic developments in such emerging markets as Argentina, Brazil, Russia, and Turkey, as well as promised growth in China and India facilitated a higher commitment of capital.  Most of these countries managed to achieve fiscal discipline and took advantage of favorable commodity prices.  They also posted faster economic expansion, compared to developed countries (almost a 3:1 ratio) since the beginning of the decade.

The successful economic performance and positive developments in financial services consequently motivated domestic investors in these economies to invest in the stock market instead of government bonds.  Risk premiums on emerging-market bonds declined, in parallel with better fiscal prospects, further encouraging both domestic and international investors to target the stock market for faster and more sustained gains.  The end result has been steady inflows of foreign and domestic capital into emerging market stocks.  The potential of making the "easy" money is still there, but investors need to keep reminding themselves that there is a reason these markets are still characterized as "emerging."

Signs of Danger   Financial markets clearly sent sufficient warning signs about volatility in 2006.  BERI S.A. is emphasizing three factors to be watched carefully in the coming years: 1- the impact of macroeconomic developments in developed countries on emerging stock markets. 2- policy measures adopted by leaders of emerging market countries. 3- political developments based on strengthening geopolitical position of emerging markets on the global arena. Although global investors generally benefited from an overall strong emerging market performance in 2006, those highly exposed to these markets experienced substantial losses because of the interplay of these three factors. 

First, earlier last year U.S. Treasury yields increased steadily as a result of upward inflationary pressures in the economy.  With better yields, risk-conscious investors suddenly pulled back from emerging markets and parked their assets in safe U.S. Treasuries.  The outcome on emerging markets was a dramatic 23.8% contraction in value within one month.  The market subsequently recovered but not before inflicting significant damage to overextended investors. 

Second, the reaction from public officials to sustained rise in values of their financial markets has been severe.  For example, the decision of the Thai central bank to directly control capital inflows into the country sent the stock market tumbling in just twenty-four hours.  The decision was partially reversed only a day later, but the damage was done both financially and psychologically for global investors.  Similar measures are likely to be introduced in other countries, particularly in Asia, to prevent sustained appreciation of their currencies.  It is important to remember that export revenue still plays a crucial role in economic growth of these economies.  Any financial development leading to the strengthening of the currency will likely meet with similar, though not as harsh, measures as was implemented in Thailand.

Finally, this is not the world we lived in a decade ago in terms of geopolitical balance.  Surely, it is still an American-dominated system, but the number of individual and influential countries worldwide has increased significantly since the beginning of the decade.  Some emerging markets, such as China and India, have become major players and will further increase their impact on geopolitical issues in the coming years.  However, some smaller countries will also exert increased influence on political affairs and contribute to substantial fluctuations in portfolio investments.  In Venezuela, nationalization steps by President Hugo Chavez have already cost investors in Latin America.  Even more danger lies ahead.  Venezuela has enhanced its economic influence on regional countries, and any decision to remove Mr. Chavez from power will have far greater financial and economic consequences for the region, and affect global investors with a sizable Latin America focus, than it would have six or seven years ago.       

Conclusion   Emerging market investment has increasingly constituted an important pillar for the diversified investor, as it should continue to do so.  However, the profit-making potential in these markets should not lead to a major modification in the level of exposure.  Some of the factors that should be closely watched are:  

1- Substantial growth in net private equity investment in emerging markets over a specified period.  Rapid expansion in asset value promises higher profit margins but also makes the portfolio investor more susceptible to risk of a downturn, which has high probability in these countries.

2- Higher lending exposure of commercial banks in emerging markets.  In recent years, loan growth in these countries has been led by corporations.  However, there has not been a noticeable economic slowdown during that time to judge whether such overextension will be detrimental to financial services.

3- The status of global economic imbalance.  Large hedge funds will make moves to protect their investment, as the global economy undergoes fluctuations brought about by imbalances.  Emerging markets will be the first on the list as corrections take place.

4- The availability of diversified investment tools.  Most emerging markets have introduced derivatives to hedge against future risks.  However, an unexpected change in market conditions does not guarantee an adequate supply of these tools.

5- Potentially increasing geopolitical tension.  In the past, geopolitical tension was more easily forecast because of the limited number of key players in the global arena.  Today, such countries as China, India, and Venezuela have more leverage, and their actions will have more of an impact on global portfolio investment than before.

The important issue to underline is that investing in emerging markets today requires a broader set of evaluation tools than utilized in the past.  The potential for devastating losses is almost as high as the potential for greater profits. 

DIRECTOR'S PERSPECTIVE Last Updated 12 February 2007

For media inquiries: Contact Saruhan Hatipoglu at sshatipoglu@beri.com