With economies soaring in Asia and Latin America, stocks have climbed throughout the emerging markets over the past decade. During the ten years ending in September, the Morgan Stanley Capital International emerging markets index returned 10.2 percent annually. That was a noteworthy performance in a decade when the S&P 500 lost 0.4 percent annually. Investors have taken notice. They have been pouring into emerging markets mutual funds and ETFs.
Have stocks gotten too rich in the booming markets of Brazil and China? Not yet, argued Andrew Miller, portfolio manager of Laudus Mondrian Emerging Markets Fund (LEMNX). Speaking at the Schwab Impact 2010 conference in Boston, Miller argued that emerging markets stocks are still attractive. “We have seen fairly consistent earnings growth across the board,” he said. “I don’t see how you could say there’s a bubble now because valuations look okay.”
Miller noted that a decade ago, the price-earnings ratio of emerging markets was 10, well below the figure for markets in the developed world. That seemed reasonable because the markets of Asia and Latin America appeared risky. But in recent years, the multiple for the emerging markets has swollen to 15—near the level of the developed world. This has caused some analysts to believe that the emerging markets have become overpriced and due for a correction.
But Miller argued that emerging markets deserve to be priced as richly as the developed world. For starters, the growth rate in emerging markets is higher and likely to stay that way for years to come, he said. Simple demographics shape the outlook. In the emerging markets, GDP is growing as the population increases and a new generation is buying houses and cars for the first time. In contrast, the population is shrinking in Europe and Japan because of low birth rates. In coming years, there will be fewer workers in the developed world to pay taxes and buy consumer goods. That will result in sluggish GDP growth.
Besides benefitting from young populations, the emerging world is free from the debt burdens that plague the U.S. and Europe, said Shawn Tully, an editor at large for Fortune magazine, who spoke at the Schwab conference. After suffering with debt problems a decade ago, many emerging countries tightened their belts, closing budget deficits and paying off foreign debt.
Tully cited a study by Research Affiliates that analyzed sovereign debt burdens of individuals countries. While the 46 emerging market nations account for 59 percent of the world’s economic activity, they are only responsible for 10.5 percent of global debt. India accounts for 8.6 percent of the global economy and only 2 percent of debt. In contrast, the U.S. has one quarter of global debt and only 14 percent of economic activity. Tully says that the debt level matters because countries will eventually have to pay their loans. To do that, governments in the developed world will raise taxes and slow expenditures. That will put a brake on economic growth. “It is clear that the growth rates of developed countries will be constrained by the enormous interest burdens,” Tully said.
Despite the growing interest in emerging market stocks, most investors remain underinvested, said Miller. Emerging markets now account for 13 percent of global market capitalization, and investors should have at least that much of their equity assets in the asset class. Typical pension funds only have 3 percent of their assets in emerging market, Miller said.
Make no mistake, the emerging markets still come with plenty of risks. Seeking to bet on growing sales of cars and houses, investors have bid up prices of China’s hottest consumer stocks to P/Es of 25 or 30, said Miller. Those levels are not sustainable. But Miller argued that the developing world may not face dangerous bubbles any time soon because debt remains under control.
He pointed to the red-hot property markets in China. Though prices have been soaring, they are not likely to collapse the way that residential markets sank in the U.S. While homeowners acquired properties with little or no money down in the Sunbelt, Chinese buyers must put up 30 percent of the purchase price to obtain a mortgage. That conservative approach should soften the inevitable downturns and enable emerging markets to keep on growing.