Value Idea: Emerging Markets- Part 2

Previous corrections have seen emerging markets lag behind developed markets by 50 per cent or more, so far it has only down by 30%. So there may be a further decline for EM index. As I argued in my earlier post this represent opportunity. But Emerging economies are not created equally: different countries pose significant inflation and credit risk. Some have trade deficits that weight heavily on their currencies and economies. Moreover, as an asset class there are several risks associated with such an investment. Lets look at the major risks:


Credit risk and downgrade

Emerging market credit conditions have peaked after five years of improving fundamentals, and a "pronounced downside" is becoming apparent to some of those economies, Standard & Poor's
said in a recent report.They argue that credit has more downside risk and very limited upside as developing economies slow and enter a rescission.

The ratings agency warned that less benign credit conditions in industrialized nations have clouded prospects for the growth of world trade, with a negative impact for emerging markets. Although the credit crises is a developed economy problem but the prospect of spillage to EM economies is a real risk from the following mechanisms:
• Counterparties. There is a direct impact through counterparty channels. The list of financial institutions liable to be affected includes all but the most isolated and remote financial service
institutions of the world.

• Risk perception. The second channel is indirect, through risk perception. The problem is that many global relationships evolve day-by-day, resulting in significant uncertainty about the way risk spreads in the global economy.

• Cost of capital. The price of risk rises substantially. This affects all asset classes that are categorized as high risk.

Out of 43 emerging market central governments rated by S&P, 33 have stable outlooks, eight have negative outlooks and only two --Poland and Slovak Republic-- have positive ones.

Countries with negative outlooks are the Dominican Republic, El Salvador, Hungary, Kazakhstan, Pakistan, Serbia, Sri Lanka and Vietnam. In the last six months, S&P upgraded six emerging market sovereign credits, most of them in the Western hemisphere -- Brazil, Peru, Trinidad and Tobago and Uruguay. During the same period, four emerging market sovereign credits were downgraded -- Pakistan, Ukraine, Georgia and Argentina -- the highest percentage of downgrades since 2003.

Here are some country thoughts on the credit risk of specific countries:
While the usual weak spots of emerging markets (eg, Thailand, The Philippines, South Africa, Argentina, Hungary) could suffer substantially in the wake of what is essentially a mature economy financial crisis, those with more robust structures — although with chequered pasts — may also be tested (eg, Turkey, Indonesia, Mexico).

At the same time, the successful new global powers are either still not strong enough (China, the Gulf states), still too isolated (India, Brazil), or happen to be in the midst of ongoing turmoil
(Russia), such that no significant global impetus can be expected to come from their direction.

Capitol outflows from EM

Capital flows to emerging economies could drop to around $550 billion in 2009 from an estimated $730 billion this year, sapping a major source of growth in countries such as Brazil and China, as per estimates: source Financial Times.

Most of the capital that flows into emerging economies has been in the form of loans, not portfolio investments, which only make up 8 percent of the total. Loans from banks and other institutions altogether make up 57 percent of total net private sector flows, while foreign direct investment accounts for 35 percent.

Moreover, in 1997-98, more debt was sovereign. Now, much of it is corporate, taken out by Indian, Chinese and other emerging-market companies. That implies a global credit tightening could have as big an impact on emerging markets as slowing import demand in the rich world.

This means the shockwaves from Wall Street's implosion over the last few weeks that have accelerated a process of risk reduction and froze money markets will likely have a direct impact on emerging market capital inflows. This will almost certainly hurt growth in emerging economies, one of the main drivers of global growth over the last year. This could slow growth in global gross domestic product below 3 percent -- a level the International Monetary Fund considers a recession.

How to invest:

I prefer ETFs to invest in this asset class; this way I avoid analysing individual companies and diversify company specific risk by holding index.

Equities:
MSCI Emerging Market Index (EEM) is an obvious one and easy to gain exposure to this assets class. I hold this one and I will continue to buy it as my equity exposure to EM. Most equities in this ETF are Brazilian and Chinese, making up to 30% of the fund. Those are very favorable countries with strong growth prospects going forward.

Specific Country ETF. You can hold individual country ETFs, however you need to do your homework on which counties have solid fundamentals. If you are going to go this route look for countries with large exports relative to their imports. These counties will see their currencies appreciate against the dollar. In this category I prefer to look at: China, Brazil, Korea and most Asian countries excluding Japan. I would avoid Turkey, south Africa and most Latin countries due to weak fiscal policies and large national debt.

EM Debt
To get exposure to EM debt is a tougher task. As a lot of the products out there are hedged and own mostly US dollar denominated debt. This obviously negate part of the reason to invest in EM, to hedge against the dollar depreciation. Local bond investments in Brazil, Mexico, and Poland remain attractive given relatively high nominal and real interest rates. I still did not find a product that would satisfy my criteria in this category, so I would rather accumulate EEM at this time than invest in suboptimal asset.