With the Middle East in Turmoil, Are Emerging Markets the Next Bubble?

From aiCIO Magazine: Despite—or, maybe, because of— continued praise and euphoria for emerging markets, some investors think the sector may be at risk of a bubble, concerned whether these relatively small markets can handle all the money flowing into them.

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Emerging markets is a phrase synonymous with double-digit returns, spurred by rising incomes and rapid economic growth. Investors have flocked to the asset class in hopes of fleeing stagnant developed economies, harnessing the economic boom abroad. They have good reason to be excited about the prospects of international opportunity: According to the Institute for International Finance (IIF), equity portfolio flows to emerging markets are set to reach $186 billion this year, more than double the $62 billion annual average seen between 2005 and 2009.

However, is this the next bubble?

Despite—or, maybe, because of— continued praise and euphoria for emerging markets, some investors think so, concerned whether these relatively small markets can handle all the money flowing into them. Their consultants also are concerned, and with the intense popularity of the sector, consultants have not embraced emerging markets without skepticism.

“Emerging markets play a role within the portfolio, but just because everyone is plowing into it, doesn’t mean everyone should,” says Rogerscasey’s Adam Tosh. Tosh does not discount the tremendous growth and success of emerging markets, but he offers a skeptical tone, expressing worry that the euphoria of emerging markets may be blinding investors from critically examining potential issues within the asset class, as huge portfolio flows pose the risk of inflating the sector’s valuations to the point of overheating. Smart investors, he says, would position themselves well by achieving further diversification with frontier markets, gaining emerging market exposure with an eye on liquidity to capture the inefficiencies of less developed economies.

Even with fears of emerging markets overheating, exposure to India and China are clearly fundamental building blocks to the extent that institutional investors are considering dedicated mandates, managing both their allocations and the investment to local managers. “In our view, emerging markets, with China and India in particular, could be candidates for overweighting as a strategic initiative over the long term,” says Bob Burke, Senior Partner and Director at Mercer’s Investment Consulting business. Burke describes the global marketplace as a two-speed world— the slowest speed being the developed world, where job creation is tepid, recovery has been halting, and long-term competitiveness of trading and manufacturing have diminished over the past five years. The higher-speed world of the emerging market economies, conversely, have recovered more quickly from the financial crisis and are expected to grow at a rate two to three times faster than the developed markets. “So now you’re trying to look at companies based in developed markets and gauging their success in developing markets. Conversely, you’re looking at strong competitors in countries like Korea and Brazil as part of a portfolio that might readily displace investments in Germany and the U.S.,” says Burke. In response to concerns about the threat of a sector bubble, Burke sees potential overvaluation in the near term. “A bubble is far away. Even long term, emerging and frontier markets are very solid investments.”

Cynthia Steer, previously at Rogerscasey and now the new Managing Director of Investment Strategy and Consulting at Russell Investments, agrees in the potential of frontier markets, yet believes that institutional investors need to be balanced when it comes to developing countries with immature and often volatile political systems. She sees a new era of investing that places greater emphasis on country risk. “Today, it’s not about the north or south; it’s about which country has the better reserves, the better balances, and the ability to absorb capital flows and deal with the monetary policy trilemma,” she says, describing the trilemma as “the confluence of stable exchange rates, capital controls, and freely set interest rates.” Steer perceives a fundamental shift from an era of asset allocation, where institutional investors would demand a percentage of emerging markets as a whole, the result being that some countries received capital that may not have been deserved. Today, however, institutional investors are paying greater attention to country-focused risk, partly due to the unrest in Egypt that sent ripples of worry throughout global markets, leaving investors fearful that the crisis could have a contagion effect (which it did). “I think we’re going to go from saying we have 20% in emerging markets to a limit on certain countries,” Steer says, noting that investors must place greater emphasis on differentiating between countries and asset classes.

Steer’s comments are reflective of a general trend among consultants who, largely driven by the financial crisis that crushed the notion of a safe haven, perceive a new paradigm of investing. According to many investment consultants, the Egypt revolt, which resulted in President Hosni Mubarak’s resignation, raised a red flag for institutional investors in that they must become more aware of the issue of sovereign debt crises. In regard to how they advise their clients, along with placing greater emphasis on county risk, they are indicating that, despite crisis in the Middle East, investors must take a longer-term approach, viewing turbulence as a natural evolution. With Egypt representing such a small percentage of the MSCI Emerging Markets Index for equities, clients with a broadly diversified plan need not be concerned, while investors with a more Middle East and North Africa (MENA) focus may need to have a more serious conversation with their portfolio managers on how to handle risk.

Amid the recent unrest and protests that have spread from Egypt and Tunisia to Libya (and to a lesser extent Jordan and Yemen), consultants have revealed that, while taking a more cautious approach to emerging markets, they have not witnessed a noticeable difference in regard to their clients voicing heightened concern about further turmoil in the sector. They note that, when markets collapsed in 2008, the more risky frontier investments were put on the back burner. Yet now, in spite of the sector’s prematurity, they’re actually beginning to see an uptick of activity.

Andy Iseri, Vice President in Callan’s Global Manager Research group, who covers international and global equity, says that he’s seen heightened activity in general—even in frontier markets, with clients looking for 5% to 10% allocations within broader emerging market strategies. He notes that the emerging markets benefited from a lack of innovation, such as mortgage-backed securities, collateralized debt obligations, and leverage, which were popular in more developed markets. “The financial crisis taught us that an abundance of innovation and sophistication got developed markets into trouble,” he says, explaining that the lack of this in emerging markets—which avoided deleveraging and toxic assets to a large degree—was a blessing. While the developed world created complicated types of leverage, which increased exposure to certain risks, emerging markets didn’t use these tools and were spared the troubles when things turned south. “I think innovation and sophistication are useful if the risks are understood and managed correctly,” Iseri asserts. “Emerging markets got a teachable moment watching what happened in developed economies. We’ll see if they learned the importance of risk management when—and if—they consider extensive use of so-called ‘innovative and sophisticated’ financial instruments.”

Investment consultants agree that political turbulence in frontier markets, with growth driven by rapidly expanding middle-class populations, should not leave investors in fear of pulling out, but suggest instead that they signal a new era of investing with a need for sovereign risk recalibration. Consultants view the continued success of emerging and frontier markets with a healthy dose of skepticism, yet they believe prudent investors should and will stay the course and continue to look ahead to capture opportunity in frontier economies, while having a heightened focus on country risk. “The onus is going to be on the investor to understand this issue, to help form and educate investment committees, to establish governance, and to create the performance systems and analytical systems necessary,” Russell’s Steer says. “We consultants and asset managers need to aid and abet this process.” —Paula Vasan