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05/17/2012

Emerging Markets Warrant an Overweight Position in Investor Portfolios, Says David Hale


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CFA Institute

Economist David Hale told delegates at the 65th CFA Institute Annual Conference that steady increases in exports and capital spending, combined with favorable demographics, will allow emerging market countries to continue to grow their economies at rates superior to those found in the more developed economies of “old industrial countries.” Given the comparatively strong growth outlook, he argued, emerging markets warrant an overweight position in investor portfolios.

In building his case, Hale noted that emerging markets have doubled their collective share of global GDP, exports, and capital spending over the past two decades, with China playing a key role in this growth. China displaced Germany two years ago as the world’s largest exporter of tradeable goods, amassing foreign exchange reserves of $3.3 trillion today (versus $3.4 trillion for all developed countries combined).

Population trends also favor investment in emerging markets. Hale pointed to aging and declining populations in Europe and Japan over the coming decades as just one reason for caution in those markets. While Korea, Taiwan, Hong Kong, and even China will also see declining populations over the next decade, other parts of Asia will see strong growth, including the Philippines, Indonesia, and India. And Africa represents another promising region for growth.

Despite the promising outlook for growth, Hale did caution that this growth has been especially volatile and punctuated by financial crises over the past two decades. These episodes included the Mexican peso devaluation of 1994 and 1995, the Russian debt default of 1998, and currency devaluations in Brazil in 1999 and Argentina in 2001. While this volatility has extended to emerging market equities, the trajectory has remained positive. Emerging market equities’ share of global market capitalization has gone from 7% in 1996 to approximately 24% today.

Looking forward, prospects for emerging market economies will be largely dependent on the economies of both China and the United States because of their size and influence. Hale expects China to overcome notable weaknesses in the areas of exports and residential real estate to orchestrate a soft landing. Despite his optimism, he warned that any meaningful downturn in China would likely be followed by a global collapse in commodity prices, which, in turn, would have a devastating effect on the economies of Latin America and Africa.

Hale is equally sanguine on the outlook for the US economy. Favorable factors include accommodating monetary policy, strong corporate profits and balance sheets, consumer deleveraging, a recovering banking industry, and a booming energy sector. In sharp contrast, Hale called Europe a “big black hole” in the world economy, somewhat troubling for emerging economies that send exports to this region.

In terms of risks for emerging markets, Hale did note a trend of “resource nationalism,” whereby emerging market governments have taken control of private enterprises or heavily taxed foreign companies operating locally. Argentina’s recently announced plan to nationalize YPF, a unit of Spain’s leading oil company, was cited by Hale as just one example of this troubling trend. Hale also noted that there remain pockets of corruption in emerging markets that investors should avoid. He mentioned Russia as one country that has yet to embrace the rule of law. Russia’s heavy dependence on oil also makes this an unattractive market for investment in Hale’s view. He is also avoiding India at this time because of inflation and political problems that are impeding economic reforms.

Which emerging markets are most attractive today? Hale favors those markets that are seeing the strongest growth, including Indonesia, the Philippines, and the frontier markets of Zambia and Ghana.

–David Larrabee, CFA

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