JPMAM: Emerging market equities - what now?

Richard Titherington, Global Head of Emerging Markets, J.P.Morgan Asset Management: "Despite continuing to be very optimistic about the long term potential of Emerging Markets Equities (EME) and that they will offer investors attractive returns, and out-performance against G7 equities, I have consistently emphasised the volatility inherent in the asset class. That volatility has certainly been evident in both recent times and historically:

"Since 1988 (chosen due to data availability not because it conveniently avoids the crash of 1987) Emerging Markets have returned approximately +10% per annum in USD compared with +7% for US equities. However that period has witnessed EM falls of more than 50% on three occasions and more than 25% on nine occasions, whilst never producing an annual return close to +10%. This is a pattern that I expect to remain over the next 5-10 years until domestic institutional investment (pension and insurance based) has grown to displace the retail speculation that dominates trading in many of the large EM countries today.

"More recently this volatility has been self-evident, but it is worthwhile breaking down the last year into its component periods to better understand what has happened and why:

"The Emerging Market asset class peaked in November 2007, before experiencing a typical EM fall of 20% over the next couple of months, then rallying strongly in through the start of 2008 until May. The summer of 2008 witnessed the onset of the bear market as risk aversion rose and valuations appeared excessive. This phase saw a 30% fall which continued until the collapse of Lehman Brothers in September, which precipitated the crisis and crash in Q4 2008 causing EME to fall a further 48% in less than 2 months.

"The period from November 2007 to October 2008 witnessed a 66% fall in Emerging Markets taking the PB ratio from a euphoric level of 3x, to a trough of 1x at the very bottom. During this period of maximum pessimism, EME began to outperform despite exhibiting very high volatility between October and February. Emerging Markets, unlike Developed Markets, did not make a new low and even outperformed by over 10% despite the overall risk aversion of most global investors. This period appeared to represent the beginning of the process of normalisation in markets as investors attempted to digest the changed growth profile of economies and consequently the implications for corporate profits and earnings.

"Since then the EM asset class has risen by 35% (as at 30.4.09), reflecting two things; firstly that the outlook for corporate earnings is better and more stable in the emerging world than in the G7 countries, and secondly that valuations close to book value are too low for an asset class with a sustainable return on equity (ROE) over 12% and a long term earnings growth rate +10%. (Currently, the JPMorgan Emerging Markets Equity Fund has a ROE of 18% and an EPS growth rate of 15%).

"I have consistently argued that investors should be structurally overweight EME because they should outperform Developed Markets equities, and rise in weightings in global equity indices over the next 5-10 years. Nothing that has happened over the last 12 months changes that view: At the country level I continue to think that the continental sized economies have a more self-sustaining growth rate and thus less dependence upon the global economy than the smaller countries within the asset class.

"As such they will continue to grow in both relative and absolute importance for global investors. Whilst at the stock level the key issue for 2009, and going into 2010 will be to identify which companies have a sustainable earnings profile given an environment of slower global growth and less abundant liquidity. Companies with exposure to domestic consumption and infrastructure investment within the BRIC countries and those which are able to generate internal cashflow to fund growth are our favoured area for investment.

"I do not expect EME to continue to re-rate as it has done over the last two months, and in fact have a preference for the PB ratio to remain around 1.5x, so my expectations for returns for the rest of 2009 are more modest. However, I do believe that the overwhelming consensus in favour of a bear market rally and thus presumably a retest of the lows of October 2008 is wrong, and that the trend over the next two years will be up albeit with significant bull market corrections of +20% and that EME will continue to outperform Global Equities and EM Debt."