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Emerging risk and return


Mukul Pal  |  New Delhi 

Emerging are fraught with as much risk as developed markets, and hence a global portfolio diversification out of equity should help.
The term 'emerging markets' was coined in 1980s by World Bank economist Antoine Van Agtmael. Businesses constrained owing to geographical locations and the transition phase from developing to developed were considered emerging.
Political scientist Ian Bremmer described emerging market as "a country where politics matters at least as much as economics to the markets". There are also the rapidly developing economies like the UAE, Chile and Malaysia, and then the BRIC (Brazil, Russia, India and China) countries or the BRIMC (with Mexico).
The latest entrants are the 'frontier markets' with countries from Sub-Saharan Africa. Zimbabwe, despite the political crisis, unhappy community, IMF cutting funds, exodus, hyperinflation and a weak banking system have seen stocks rise to a new two-year high. Strange as this may all sound, emerging are fraught with risk and need a keen comprehension to invest profitably.
We are not going that far to the riskiness of the frontier and will focus on the top 30 countries (see chart). Though some of the exchanges and regions under study have a history as long as 130 years (India), most of the emerging market indices have an average 14 years of price history.
The available history for the Sensex goes back as just more than two decades. Romanian and Bulgarian indices stand at 11 years and 8 years respectively. Index histories are significant and do highlight the divide and maturity of developed from developing markets. The recorded price history for the Dow goes back to the 1880s.
To expect markets and market participants to find real value, equity value over just a few decades is presumptuous.
But why just emerging market equity? Especially considering that over the last 100 years of peace time, equity has given a return of 1 per cent over debt. Why despite such a marginal difference, equities crowd our minds as the most popular asset class?
The answer to this question is like what Edward Dewey mentions in his book Cycles, "Mankind's' favourite vocations are speculation and war." And modern economics defines speculation as a good word, with an economic utility much beyond trading volumes.
The last seven years, witnessed an average 206 per cent return on emerging markets. India registered 157 per cent. And Peru was the top performer with 388 per cent. The maximum annual returns averaged 84 per cent for the emerging markets. India was an inch lower with 73 per cent. The maximum annual declines polarise the 30 countries apart. The average drawdown was a fall of 11 per cent. India's worst year registered a drop of 18 per cent. This was despite scams and political crisis that seemed to shock the market in June 2004.
The drawdown list also highlighted the more risky regions. For example Venezuela, Jordan and Egypt all registered a year with more than 30 per cent decline. Jordan was the worst performer with a yearly dip of more than 33 per cent.
The average annual returns for 2000-2007 stand at 30 per cent. India registered 22 per cent. Seven countries--Bulgaria, Colombia, Egypt, Peru, Romania, Russia and Venezuela--registered average returns of 50 per cent. No wonder an emerging market investor continues to seek near 50 per cent annual returns from his equity portfolio.
Though emerging markets have less history to conjure such surprises, the correlations and linkages between markets are increasing. The sectoral link comes first.
A study of top exports from the region throw out an overlap of textile, metals and mining, oil and gas, machinery and equipments and agro-based sectors.
Call it the textile effect, but with cotton prices at a decade low, a part of the sector does have an inexpensive underlying commodity. Our cotton shirts have not become cheaper over the last 10 years, but more textile companies have sprung up across the sector.
Similarly we have the Peru effect, an economy driving its strength from copper and gold, till the commodity goes up, so will the economy. Metals and mining does give the emerging region a reason for growth and dependence on the sector. Oil and gas is another sectoral overlap, with most emerging economies relying on energy resources for exports.
Overall, the reliance on a few sectors does increase the riskiness of emerging markets. We definitely have differentiators here in terms of technology exports from India.
Sectoral representation is still weak in emerging markets. Not only are the sector indices less watched and tracked in emerging markets, but many emerging markets indices are also made of a few sectors. Then there is the currency risk concern. We studied the lei (Romanian currency) along with the euro, rupee and yen.
Sometimes a currency risk is beneficial, like in the Romanian case where a simple Lei deposit returned an annual 15 per cent returns after the currency appreciation was taken into account. The rupee has just broken its multi-year high.
The last seven years, however, did not add a sizeable benefit to emerging market investments in India. This is in complete contrast to developed market currencies like yen, where multi-year sideway movements have left currency risk management a tricky affair.
Though beneficial, the emerging market currency risk is still driven by local factors. And considering the sector outlook for the emerging market region is driven by global parameters, we need a global hedge in case of a meltdown. This is where we looked at gold.
In terms of gold, the Romanian BET Index and the Sensex are still below previous year highs. Gold valuation reflects another picture of the emerging market equity around the world. The real value as it stands is not the emerging market currency but gold. The situation looks disastrous when we consider the Dow value in gold. Without adjusting for currency weaknesses, this value has been crashing since 2000 and never rose.
This is the reason a global portfolio diversification out of equity should help. And something contrarian like agro and food prices, which are considered inexpensive and free might be just the low risk entry we need to reduce the overall emerging portfolio risk.
For example, the water index has given an annual return of 50 per cent over the last two years, better than oil. It's from this basket of alternative energy assets that we have the solar index, the bio energy index and even the renewable energy index. Agro, we feel, is an extension of the renewable sector. And with a 10-year and multi-decade low prices, we have taken agro more than granted. And this is going to change. Food prices are set to increase.
The market outlook that matters the most to not only emerging equity markets but also the global economy is the oil and natural gas sector. A new high between $80 and $100 is in for oil late 2007 or early 2008.
Similarly for natural gas, the hedge fund busts and all the negativity around the asset has pushed it not only to low levels but also low on the popularity scale.
This is the reason we consider the current prices as a low-risk entry point at the current $6 level with potential targets of up to $20. Emerging markets have their risk and return and understanding the complete picture was never as imperative as now.
The writer is CEO, Orpheus Capitals, a global alternative research company

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First Published: Mon, April 23 2007. 00:00 IST