Rewards and risks go hand in hand

Coming just days after the assassination of Benazir Bhutto in Pakistan, the violence that erupted after Kenya's disputed year-end election has been a grim reminder that high rewards always come with high risk. Of all the countries enjoying the economic resurgence in the resource-rich continent, Kenya would have been the last most people would have predicted to blow up like this.

John Mackie, who manages the Africa Equity Fund for Stanlib, the asset management arm of South Africa's Standard Bank, says: "We are shocked by what's happened in Kenya. It has always been a pillar economy in the region."

Mackie says it is a wake-up call, because "Kenya was an established market, with depth of liquidity. In other markets you worry about the macro picture but here it was more about picking the right stocks."

When Stanlib launched its fund in August it joined others riding a wave of confidence in the nascent African growth story. Investec and New Star have also raised money to invest in this huge untapped frontier market. Since August, the Africa Equity Fund has risen in value by more than 20 per cent and now has $110 million under management.

Roelof Horne, Africa funds portfolio manager at Investec, typifies the new-found caution. "We will be watching carefully, but will not be making any rash moves. While attractive returns have been generated across the continent, political risk must always be taken into account,'' he said.

As money has flowed into more traditional emerging markets, such as Brazil, Russia, India and China, investors have become more willing to try new regions, and Africa has been seen as one of the most attractive.

Mark Mobius, manager of Templeton Emerging Markets Investment Trust, says: "Africa has benefited tremendously from rising prices fuelled by the rapid growth in other emerging commodity-importing economies."

It is not just a raw materials play. "Large-scale debt-relief programmes have enabled structural and regulatory reforms to place the continent on a path to sustained growth," Mobius adds.

Most specialists agree that the events in Kenya and Pakistan are irrelevant to the rise of the world's developing economies. Jerome Booth, emerging markets expert at Ashmore Investment Management, believes investors need to reassess the way they view the world. "Emerging markets represent 85 per cent of the world's population and emerging market asset classes could account for 50 per cent of global market capitalisation in 15 years. It is possible to argue that pension funds should put 35 per cent of their assets in emerging markets now."

He is contemptuous of the view that emerging markets are more dangerous than those in the developed world. "All markets are risky. The emerging markets are those where this is priced in."

Exchange rates

Booth believes the greater risks are in markets seen to be the safest. "Looking at debt/GDP ratios, fiscal and current account surpluses, reserve levels, inflation and flexibility of macro-economic policy to events, one could be forgiven for concluding that emerging markets are collectively much better credits than developed markets. And where have people lost money recently?" He believes many emerging markets will enjoy the tail wind of appreciating currencies. "Exchange rates could rise by 30 per cent against the dollar over the next two years or so."

A key message is not to tar all emerging markets with the same brush. There is a world of difference between true frontier markets - such as Vietnam and Kazakhstan - and the emerging giants of the new world economy, and second liners such as Indonesia and Turkey.

James Weir, responsible for Asia ex-Japan investments at Atlantis, says: "We look for under-researched stocks and there are plenty of these in the larger markets. Towards the end of 2007 lots of people were talking about frontier markets but we take a more risk-averse approach."

Weir says emerging markets have been transformed since the upheavals of 10 years ago, pointing to strong sovereign balance sheets, economic growth despite the US slow-down and strong and strengthening currencies. The only unanswered question is the extent to which the good news is already factored into developing market share prices. Again it is unwise to generalise, because there is a huge variation in the valuations of different markets. The Brazilian Bovespa index trades on a multiple of earnings in the low teens, whereas the price-earnings ratio of Bombay's Sensex index is in the high twenties. China is even more expensive but Booth cautions against calling the Shanghai market a bubble.

So while the street violence will continue to grab the headlines, emerging market investors remain focused on the bigger picture - a shift in the locus of economic power from the developed to the developing world and a step change in the resilience of emerging markets.

Diversification is the key, Stanlib's Mackie says. "I won't beat around the bush. What's happening in Kenya is a shock. But remember most investors' exposure is very small. Fund managers have bought the story. They know these things can happen."