Chris Andrews examines the opportunities provided by emerging markets for pension fund investment

The decision in early August by ratings agency Standard & Poor's to downgrade the United States' perfect credit rating was telling; nowhere, it seems, is 100 per cent safe. While in reality the default prospects between AAA and AA+ are miniscule, S&P's move struck a psychological blow to the country's administration, and made the waters of the world's safe harbour just that bit choppier.

Indeed, examining both the American and European markets over the past year, the overriding themes have been market volatility, and the domino dropping sovereign debt crisis on both sides of the Atlantic. As increasing scrutiny and decreasing prospects surround even the most developed of the developed markets, pension funds are looking for ports in which to shelter from the ongoing storm, and those ports increasingly appear to be in emerging waters.

We are currently in a global growth crisis, says ING Investment Management emerging markets equity strategist Maarten-Jan Bakkum. "And if you accept that then of course you have to look for markets where growth is actually better, and where the drivers of growth are not so much linked to global trade or to developed market flows."

In that current economic environment, if a pension fund wants growth and a chance for decent returns, says Bakkum, that means it has to look to emerging markets. "Everything that's happening now in the US and Europe confirms that big time," he says.

This isn't to say that the emerging markets are not without their own problems, but those problems do not mirror those of the developed world. During the course of the past year, concerns over inflation in many developing markets have led central banks to tighten up monetary policy in an effort to control growth, and to keep inflation from spiralling out of control. This has meant that, in particular, financials in those countries have not been particularly attractive to investors while that tightening has gone on.

"The concerns in developed financials are different," says BNP Paribas Asset Management CIO global emerging markets equities Gabriel Wallach. "They are much more related to sovereign debt issues and banks holding debt of countries that may either restructure their loans or actually default."

It is arguably this policy tightening, among other things, which has actually led to emerging markets underperforming against their developed counterparts over the past year, but this is not something which should put off investors.

In an investor note from August, HSBC Global Asset Management global head of macro and investment strategy Philip Poole said that this underperformance was not meant to last, and should be seen as a 'one-off rotation', resulting from investors re-pricing an improved view of the sustainability of developed market growth and so shifting their portfolios.

"We believe that 2011 will prove to be a year of two halves," he said. "The increasing realisation on the part of the investor community of the necessity for de-leveraging in the developed world and the negative consequences for companies focused on demand there is likely to re-balance investor sentiment from developed to emerging equity markets. The positive trends are likely to come out of the emerging world. As the implications of excessive leverage in the developed world become clearer - an overall drag on developed world growth and corporate profitability - we believe that net underlying flows will shift back to emerging markets helping these markets outperform developed markets in the course of the second half."

What this means is that for pension funds considering increased allocations to emerging markets, the time could be ripe to do so. "If you were underweight in emerging, this would probably be the time to be adding to it, because I think it will start to outperform," says Wallach.

He argues that while the aggressive policy moves of central banks understandably raised concerns about a slowdown in emerging markets, "the tightening cycle is most definitely over in China, Brazil and India, and the sovereign and corporate balance sheets are much healthier in emerging than in developed, and the valuations are much less expensive".

M&G Global Emerging Markets Fund co-fund manager Matthew Vaight believes that during the recent stock market turmoil investors have been focusing on macroeconomic problems in the US and Europe resulting in companies being sold regardless of their actual prospects. "Such negative top-down factors offer excellent investment opportunities in global emerging markets for investors who have a bottom-up approach," he says. "Volatility can certainly present opportunity."

Finding ports
It is, of course, a matter of finding those opportunities, as emerging markets are by no means a homogenous mass. Theoretically, as Bakkum points out, markets heavily reliant on exports to the US and Europe will suffer under current conditions, and countries driven by domestic demand will outperform.

"So things which are linked to the US and Europe, you want to see as little of that as possible," Bakkum says. "So you look for markets that have strong demographics, like Indonesia or India for example, you look for markets where there is still room for fiscal stimulus, where there is very low public debt or the government budget is just very good, and you think about places like China and, again, Indonesia as well."

Wallach agrees, saying his firm is underweight in emerging Europe, in particular Turkey and Eastern Europe, as their export exposure to developed Europe is high and their currencies are linked. It's a similar case for Mexico, which has very close manufacturing links, among others, with America.

But this is not a hard and fast rule, and illustrates the necessity for scrutiny and bottom up stock picking.

The power of policy
The country which seems to be a continued favourite for most emerging market investors is China. While true that China is largely tied to the world economy, with a heavy export base to the US and Europe, its main drivers of growth have been within the domestic sectors, according to Bakkum. Back in 2008 when many Chinese exporters were going bust as Western demand dried up, the government stepped in with an enormous fiscal and monetary programme to stimulate the domestic economy and offset pressure from decreased global trade. Not having to worry about hundreds of sub-committee meetings to push a policy through, the Chinese government can implement these kinds of measures much more quickly than their western counterparts.

Ironically it is that very ability of the Chinese government to act quickly and decisively which presents potential long-term risk for investors in that country.

"I think for the long term the Chinese model involves huge risks, and at some point they will be up against the wall because they have pushed the banking system too much and put far too much credit in the system just to keep things going. But for the time being, I think it is an asset because they can do more than other countries can in difficult times," says Bakkum.

This, again, highlights the point about active management, and the ability of managers to move their portfolios in accordance with the current economic environment - this is no place for static allocations.

"And that's not just emerging market equities," says Cardano head of clients Richard Dowell. "There are a range of different investments which we think trustees should be looking at in emerging markets, but also over time rotating where they invest in order to get access to the best opportunities, thinking about both risk and reward.

"The emerging markets themselves aren't all the same, and you need to look closely at where you want to invest, but also look at a range of investments, such as EM FX - this is something we find attractive at the moment. Looking at emerging market debt as well, both government and corporate."

Dowell says that historically the level of risk associated with emerging markets has been much higher than developed, and in that regard risk/reward characteristics between the regions have definitely narrowed. "And I think one could argue that in some cases some developed markets are more risky than some of the emerging markets nowadays."

"But again, it's a balancing act for managers," he says. "And this is why you want managers who will rotate their portfolios, and won't necessarily be hugging a benchmark."

And this is really the point. In the current climate, as with the US downgrade, nothing is 100 per cent. Some managers are now giving emerging market scrutiny to developed market investments, and trustees need to be open to opportunities. While no one is suggesting upping sticks and throwing everything into EM, there is a strong case for allocations to act as a defensive measure in the face of volatility and debt issues in the developed markets, and to seek increasing returns as the emerging markets return to outperformance.

Written by Chris Andrews, a freelance journalist

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