Emerging Markets Outlook 2008 – Strong commodity prices expected to support growth

Fueled by strong domestic consumption, robust exports and continued strength in commodity prices, the emerging markets outlook in 2008 for economies in Latin America, Eastern Europe, the Middle East and Africa is for healthy average growth of 4%. That should mean another good year for the regions’ markets, but they are not threat-free.

“The prospects for emerging markets, on the whole, are good,” says Charles Bastyr, chief investment officer at Meadowbank Asset Management Inc. in Toronto. “But performance in 2008 will most probably be weaker than in 2007.”

He argues that average valuations in some markets are relatively high, although not excessive.

But, counters Mark Grammer, vice president of investments at Toronto-based Mackenzie Financial Corp. and lead manager of Mackenzie Universal Global Future Fund, the higher valuations will probably be balanced by lower risk premiums. He suggests the best returns will come from stock-picking rather than a general market rise that tends to boost all stocks, as has been the case in recent years.

A pillar of strength in these markets will probably be commodities. Singapore-based Mark Mobius, manager of Templeton Emerging Markets Fund, which is sponsored by Toronto-based Franklin Templeton Investments Inc. , sees no let-up in commodity prices. A stock-picker who believes that many emerging-market companies are undervalued, Mobius sees attractive valuations in certain stocks in Brazil, South Africa, Turkey and Russia.

Patricia Perez-Coutts, vice president of AGF Funds Inc. in Toronto and manager of AGF Emerging Markets Fund, is also counting on high oil prices and strong demand for commodities. Demand for steel, copper and iron ore will continue to buoy the Latin American economies of Argentina, Brazil, Chile, Mexico, Peru and Venezuela, she says.

Many portfolio managers are high on Brazil, Turkey, Egypt and South Africa and are finding good opportunities in Mexico and Russia.

But there are clear threats to the generally positive picture. The U.S. slowdown will weigh on all emerging markets, slowing growth slightly as exports are dampened. But, Perez-Coutts notes, Latin American exporters have “been very swift in diverting exports to non-U.S. destinations,” thereby reducing their dependence on the U.S. Many emerging countries export to China. As a result, their prospects are also affected by what happens in China, and most analysts expect China’s growth to be only slightly slower this year than in 2007.

The impact of the global credit crunch could hit emerging markets harder than developed markets; emerging markets rely on capital for growth and the crunch is taking liquidity out of the market, says Grammer. And political risk is always a major consideration, he says. Although the elections cycle is over for Latin America, he notes that political interference in Russia and election tensions in South Africa could present challenges in those two markets.

Here’s a look at specific markets:

> Latin America. “What’s important to look at in Latin America, and especially countries such as Brazil and Mexico,” says Perez-Coutts, “is sustainability of growth, which is being driven by domestic and infrastructure spending and a bounce in commodity prices.”

She says there is enough cash in government coffers that growth is sustainable “beyond three or four years.” This, she adds, “sets the region apart from where it was 10 to 12 years ago.”

At a sector level, Perez-Coutts favours consumer, banking, life insurance and infrastructure (construction, transportation, roads and logistics) stocks in Latin America. Although Brazilian valuations have picked up, she considers stocks in Mexico to be still fairly valued.

Mobius likes raw materials, telecoms and banking in Brazil.

Other Latin American markets — Argentina, Chile, Colombia and Peru — are not typically on the radar screen, says Bastyr.

Perez-Coutts agrees, noting that there are few investment opportunities, barring indirect investments in large global corporations that invest directly in these countries.

> Eastern Europe. Emerging Europe is expected to continue to grow on the back of convergence in an expanded European Union. But, Grammer says, it faces the risk of a slowing Western Europe and a stronger euro that will hurt exports.

In addition, says Bastyr, investments in infrastructure will probably dry up. Large European banks, which were hit by the credit crisis in 2007, have put a hold on many projects. He adds that the stock markets of many emerging European countries are relatively small, have limited liquidity and few quality companies of size.

Clouds on the horizon include a slowdown in the U.S. economy and the global credit crunch

Still, Mobius has found opportunities in pharmaceuticals, value-added industries, high-grade machinery and property in the region.

Perez-Coutts likes consumption and infrastructure plays in Turkey. Despite last year’s substantial political difficulties, associated with presidential and parliamentary elections, Turkey is experiencing relatively strong growth, falling interest rates and healthy foreign direct investment flows. In addition, she finds valuations relatively low while earnings potential is high.

Russia is a wild card. Bastyr believes that if basic materials and oil prices hold up, Russia could emerge as one of the best-performing emerging markets in 2008. However, political risk is a major problem as the government increasingly leans to the left.

“The potential downside is greater than the upside,” argues Grammer.

Perez-Coutts, on the other hand, points to strong fundamentals in Russia, especially related to domestic consumption. She does note that high valuations make it “difficult to achieve a decent entry level.” But she, too, notes the political risk.

Grammer says the flat tax rate in many Eastern countries —Romania, Slovakia, Ukraine, Lithuania and Estonia — is advantageous to businesses. Property values will continue to rise because of a repricing of assets, although at a slower rate than in the past two years. In addition, the shift of production to emerging Europe from Western Europe because of the enlargement of the European Union has resulted in the formation of strategic alliances and partnerships between companies from Western and Eastern Europe, accompanied by the transfer of Western management expertise and skills, he adds.

> Middle East. “Egypt is currently among the most favoured markets among international inves-tors,” says Grammer. The telecom sector is dominant, comprising almost half of total market capitalization. The oil sector is largely closed to foreign investors, but opportunities exist in industrials, petrochemicals, real estate and utilities.

Mobius has Middle East investments, but Perez-Coutts cautions that the region will be “driven by how oil performs.”

> South Africa. Mobius likes consumer banking and retailing here. The country is benefiting from higher productivity and consumption because of a younger and better trained labour force. A rising black middle class is also fuelling consumption, he adds.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

More articles by Dwarka Lakhan