Emerging Markets Back in the Spotlight

by Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
July 21, 2009

Reprinted from the July 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

The worst economic downturn since the Great Depression may be coming to an end, and many investors are starting to reexamine their portfolios. Emerging markets, which have greater reward potential to go with their higher risk, may have pulled back in the past month, but they still offer a compelling case for investment.

Developed-market growth constrained
Because the economies of developed nations are more mature than the economies of emerging markets, they don't have the same growth potential. Growth in the United States is constrained by its large size and by reduction of consumer debt—likely a multiyear process.

European growth is limited by highly leveraged banks, reluctance of member states to provide fiscal stimulus, and strains on a single-currency system.

Meanwhile, Japan still suffers from anemic growth, constrained by an aging population and limited consumer spending growth.

Emerging markets posted strong returns in 2009: Are there still opportunities?
The outperformance of emerging-market stocks in the first half of 2009 has been largely driven by China's $585 billion stimulus program, which the government was able to implement quickly. In March, the Chinese economy was the first to return to growth, and world economies have benefited in turn.

Commodity-related markets have experienced the strongest stock returns, as the Chinese stimulus has a strong infrastructure spending component and emerging markets have roughly double the commodity exposure relative to the S&P 500® index.

However, the case for emerging markets is more than just a 2009 phenomena. As you can see on the chart below, growth prospects for emerging-market countries are forecast to be much higher than those of developed countries, thanks to market-oriented reforms, rising middle-class consumers and demand for natural resources.

We believe these changes will power growth for years to come, while stock valuation measures remain below five-year averages.

Chart: Emerging Markets Growing Faster

Transition to open-market economies improves growth
Many emerging markets are embarking on economic development and reform programs as they transition to open-market economies.

As a result, barriers to growth, such as tariffs and protection from competition, are lower. Government-owned companies are passing into private hands, reducing inefficiencies and raising productivity and profitability—in turn increasing economic growth and incomes.

For example, India's investment prospects may rise due to political changes. In May 2009, Manmohan Singh was reelected prime minister, and the balance in parliament changed in favor of his party.

Singh, an Oxford-trained economist, introduced free-market policies as finance minister in 1991, helping the economy quadruple in size, and hopes are high for extended market-oriented reforms.

Rising middle-class consumers
Of course, consumer spending is vital to developing more market-based economies, and Chinese consumers are in a position to keep spending (unlike their US counterparts, who are largely deleveraging)—even after government stimulus measures end.

The Chinese, like many Asian consumers, have a high savings rate (nearly 30%) and low debt levels, especially compared to US consumers.

Consumer spending represents just 35% of Chinese gross domestic product, compared to 70% in the United States, leaving cash on the sidelines to be spent as consumers are exposed to more of the "luxuries" enjoyed in the United States and Europe.

As an example of the move to more Western spending trends, technology adoption in China has been rapid—the country now has 641 million cell phone users and 300 million Internet users—and is set to rise further as consumers move away from low-end products and services.

While car sales in China have grown tenfold since 2001 (see chart below), China is just now surpassing US annual car sales—despite having four times the population.

Chart: Chinese Consumerism on the Rise

As a result, Chinese oil consumption has nearly doubled during the past decade, making China the world's second-largest consumer of oil, behind the United States—yet per-capita consumption is still just a fraction of US consumption.

And it appears income levels in emerging-market nations still have plenty of room to climb compared to the United States and the United Kingdom.

The rising middle class is not just a China story; it provides fuel for further economic growth in many nations. According to McKinsey & Company, the Indian middle class currently numbers about 50 million people, and should grow to 583 million by 2025, with income levels growing to an estimated 11 times those of today.

As income levels grow, middle-class consumers earn discretionary income to spend on consumer goods deemed "necessities" in developed countries.

In addition, demand emerges for financial services such as credit cards, insurance and investment services. And there's still plenty of room for the adoption of financial products: For example, only 15% of Brazilians have bank accounts, and there are currently only 300,000 mortgages outstanding in Brazil.

Natural resources in high demand
As the middle class grows, however, companies and consumers require more reliable internal infrastructure systems. This, in turn, increases the demand for commodities and the industrial goods needed to construct buildings, bridges, railways, and utility and water projects. Thus, emerging economies now account for almost 40% of world oil consumption.

As China, the behemoth of emerging markets, becomes more urbanized, it has become the world's largest maker of steel and the largest user of coal.

The runway for growth in China is long, as the government anticipates 45 million new city dwellers in five years—equal to more than five times the population of New York City! Urbanization in China is currently 46%, compared to more than 80% in the United States, the United Kingdom and Korea.

Much like China, but further behind the curve, India has an infrastructure badly in need of investment, as most electricity is currently produced by the public sector; power outages are common and the use of generators is prevalent. Road and transportation networks are also very inefficient, slowing the delivery of goods.

Natural resources plentiful in some emerging nations
While rising demand for natural resources could cause problems should such materials become scarcer, another part of the emerging-market picture could benefit from greater demand.

Many Latin American countries, as well as Russia and South Africa, are rich in natural resources. For example, the Tupi field off the coast of Brazil was heralded in November 2007 as the second-largest oil discovery in the past 20 years while Russia produces 20% of the global oil and natural gas supply and is the world's second-largest oil producer, behind Saudi Arabia.

And it's not just oil and gas—as incomes rise in developing nations, people consume more meat and protein, as well as fresh fruits and vegetables, displacing starch-based diets. The USDA reports that it takes seven pounds of grain to produce one pound of meat. Brazil's temperate weather and vast amount of land have turned Brazil into an agriculture powerhouse.

Despite volatility, emerging markets offer diversification
Despite high growth prospects, some investors have begun to question the long-perceived value of diversification that comes with investing in emerging markets. Certainly, countries are more interrelated than they were a decade ago, and the unprecedented nature of the recent economic crisis was largely indiscriminate and sent all markets lower.

However, we've seen that emerging-market countries have unique factors driving growth. As such, we believe that, as the crisis continues to subside, diversification benefits will remain in emerging markets.

Of course, the old investing axiom "With higher return potential come higher risks" still applies, and we'd be remiss not to mention key areas of risk, which could cause some significant bumpiness in our longer-term positive investment outlook.

Fiscal discipline
A primary cause of past crises in emerging markets has been the running of persistent deficits, funded by debt. As debt levels rose, investor confidence waned, in turn forcing interest rates higher. Governments paid down debt by printing money, resulting in sky-high inflation, low economic growth and currency depreciation.

While this risk still exists, fiscal discipline has certainly improved, and many emerging countries now enjoy investment-grade ratings, having addressed past problems with high inflation and debt levels.

A great example has been Brazil, which has successfully pursued fiscal discipline for more than a decade—consumer inflation is now 5.1%, as you can see in the chart below, versus 5,000% in 1994.

Chart: Brazil's Hyperinflation Tackled

Political risk
There are big differences among emerging countries with respect to political risk. Some economies have relatively stable democracies, while others have communist regimes that bully their way into private enterprise, as in Russia and Venezuela.

And, while China's quick implementation of its $585 billion stimulus program helped to quickly influence growth prospects, a downside is that the government can also directly intervene in industries, changing the rules and hampering growth prospects for the companies involved.

Another ongoing political risk, both here and in emerging markets, is creeping acceptance of protectionism—as often occurs during times of crisis. A government can enact protectionist measures that favor local companies over foreign ones, reducing investor confidence and subsequent capital flows to the country.

Limited access to information
Not all countries report earnings using the same accounting rules as the United States, and some only report financials once or twice a year.

And some countries lack the transparency, investor protection regulations and corporate governance that exist in developed markets. Additionally, it can often be difficult to get information on economic data, current and relevant news, product releases and competition.

For example, while China has led the world in economic growth, government-issued economic statistics are viewed skeptically, with many experts believing that the data is "smoothed." As a result, investors need to try to gather data from multiple sources to evaluate ongoing investment.

Overly high expectations
Despite the recent pullback, emerging markets have strongly outperformed during the first half of 2009, and expectations remain high for continued growth—particularly in China. The transition to a consumer-driven economy in China has a long path of potential growth, though progress will be slow and gradual, and marked by near-term dependence on exports.

Ways to participate
We believe that investments in emerging markets have potential for long-term growth, and because the pullback in these markets has taken valuations below five-year averages, opportunities exist.

However, emerging-market investing can be more research-intensive, so exchange-traded funds and mutual funds may be more appropriate if you don't have the time or desire to research and monitor emerging-market investments.

If you do wish to invest directly in emerging-market stocks, many American Depositary Receipts (shares of ownership in non-US companies) trade on US exchanges.

Additionally, there are many US companies that may be poised to benefit from infrastructure and consumer spending in emerging nations.

To find these, try to tilt your portfolio toward sectors with high international exposure, such as materials, industrials, energy and technology. Just be sure to diversify by company and country, and consider dollar-cost averaging, given the potential volatility.

If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investments and strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and are not intended to imply future results.

Past performance is no guarantee of future results.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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