Exploring the frontier markets in 2009

The year 2008 was the year that ended a long bull run in emerging markets.

The MSCI Emerging Markets index declined 51 per cent, (as of December 18, 2008) in 2008, after surging an astonishing 400 per cent in the preceding five years. During that five-year period, some regions performed even better, with the BRIC and Latin American indices jumping as much as 700 per cent while Eastern European markets soared 500 per cent.

The recent fall is part of the natural cyclicality of public markets, which experience both, bull and bear periods. The important point to remember is that bull markets last longer than bear markets and bull markets go up more in percentage terms than bear markets go down.

Since we started the first emerging market fund in 1987, there have been nine bull and bear periods. The average length of the bear markets was six months while the average for bull markets was 22 months. While the average decline of the bear markets was 32 per cent the average increase in the bull markets was 113 per cent. We expect these patterns to be sustained in the coming decades.

Global financial markets during this year have been one of the most volatile since the 1930s. The last serious bear market originated in Asia in 1997 but this 2008 crisis originated in the US. Most critical for 2008 was the unravelling of the highly leveraged derivative structure of subprime mortgages in the US. This has resulted in global financial panic. Extreme risk aversion has led to a drying up of liquidity, tight credit conditions, problems for companies based on highly leveraged finance models, the collapse of several major financial firms in the US and Europe as well as high volatility in global emerging markets.

During 2008, emerging market currencies weakened against the dollar as a result of the rush to the dollar and US Treasury instruments. Investors sought "safe havens" and US Treasuries were considered the safest haven. US corporations were faced with a liquidity squeeze and sold assets overseas to remit funds home. The fall in emerging market currencies, however, is quite different from the currency crises in the 1980s and 1990s.

At those times, emerging market currencies were impacted by poor fundamentals such as balance of payment crises, excessive debt, underdeveloped banking systems and heavy US dollar borrowing. At that same time, the US economic fundamentals were good. The situation is now reversed and the weakening of emerging market currencies was caused by the rush into dollar by global investors. However, with a higher return on capital and higher growth prospects, emerging markets should eventually attract capital.

The major difference between the current global environment and the Great Depression in the 1930s has been the earlier and rapid proactive approach of global governments to take unprecedented actions to support their economies and financial systems.

Recognising the severity of the credit crunch, in October major developed and emerging central banks lowered interest rates in an unprecedented globally coordinated monetary policy effort.

This was followed by the implementation of fiscal stimulus measures and loosening monetary policies from governments and central banks in developed as well as emerging markets. Thus far, more than $1 trillion has been pledged by governments around the world to rejuvenate their domestic economies including China, the US, Germany, the UK, Taiwan, Spain, Japan, South Korea, Russia, France, Australia, Hong Kong, Singapore and Malaysia.

In addition to emerging markets, frontier markets also present attractive investment opportunities. Frontier markets include economies at the lower end of the development spectrum. They are generally smaller and less developed than other emerging markets but have the potential to grow at a fast pace and could become tomorrow's emerging markets. They are where many emerging markets were 20 years ago when we started our first emerging markets fund. By offering investors with the opportunity to invest in a "younger generation of emerging markets", frontier markets provide an attractive investment opportunity. Many of the characteristics that have made emerging markets fascinating to investors are now becoming increasingly evident in frontier markets. These characteristics include: positive economic trends such as high growth, high potential for capital market development as well as the presence of attractively valued companies.

Another interesting area is emerging market small capitalised companies that have the potential to deliver substantial capital appreciation as they transition to becoming well-established large-sized companies. Identifying them early and investing in them with a long term perspective can be highly rewarding.

Many emerging markets have relatively higher GDP growth, trade surpluses, high foreign reserves, as well as strong investment and domestic demand - an environment where well-run, small-cap companies can flourish.

We expect the BRIC economies to continue to be a key driver of global economic growth. They are among the fastest growing economies in the world. The four markets together account for more than 40 per cent of the world population.

Domestic demand growth also remains robust. Moreover, Brazil and Russia are resource rich countries and although there has been a recent fall in commodity prices, the longer trend for commodity prices is up and these countries will benefit from global demand for oil, steel, aluminium, pulp, and other commodities. China continues to take great strides towards becoming a major global player. Its foreign reserves recently surpassed $1.9 trillion.

India continues to be a key centre for major sectors such as pharmaceuticals and software.

Within this environment, we have focused on the "3 Cs" investment themes, consumer, commodities and convergence. With rising per capita income and strong demand for consumer and other goods, the earnings growth outlook for consumer oriented stocks remains positive. We continue to like commodity stocks because many of them have declined significantly below their intrinsic worth and we expect the global demand for commodities to continue its long-term growth. Additionally, convergence between global economies will continue to provide good opportunities for financially strong companies who will take larger market shares and consolidate their industries globally.

Given the steep market decline, investors have begun to shift their focus to the increasingly attractive valuations in emerging markets. Many markets are trading at single-digit price-to-earnings ratios, with many companies trading at below their net asset value. Stock prices rebounded in December as investors sought to benefit from the attractive investment opportunities in the asset class. As of mid-December, emerging markets looked set to end 2008 above their year-lows.

Today's emerging markets are quite different from when we started the first listed emerging markets funds 20 years ago. Emerging markets today are better regulated and have improved transparency. The legal, financial and technological infrastructure in most markets is also much more advanced. Moreover, emerging market companies have higher quality accounting standards than in the past.

Many of the emerging countries, Asian countries in particular, have built up sizeable foreign exchange reserves and thus are better able to withstand turbulence brought about by external forces.

While we believe that the longer-term outlook for emerging markets remains positive due to the relatively strong fundamental characteristics and faster growth rate than their developed counterparts, 2009 is expected to be challenging. We can expect more volatility in view of slowing growth and recession concerns in major world economies, volatile exchange rates and commodity prices, and a global credit crunch. While inflation was a major concern in 2008, a correction in commodity prices eased fuel and food prices in many economies allowed inflation to subside in the latter part of the year. This has enabled emerging market countries to not worry about higher inflation but take measures to stimulate growth by lowering interest rates and take other fiscal measures.

The perception of risk in emerging markets is now beginning to shift as investors realise that: (1) emerging markets have become net creditors with vast holdings of foreign exchange reserves, (2) emerging markets continue to record much higher economic growth compared to the developed countries and (3) the debt levels of many emerging market countries is lower than that of developed countries.

China now has $1,900 billion in foreign reserves, Russia has $437 billion, South Korea's total is $200 billion, Taiwan has $281 billion, and India has $246 billion. Average economic growth in 2009 for emerging markets is expected to be 3.8 per cent compared to a 0.8 per cent decline for developed countries. For example, while China is expected to grow by 8.1 per cent, the US economy is expected to contract by 0.6 per cent. The total debt to GDP ratio of emerging countries averages 94 per cent, while the ratio for developed countries is 233 per cent. Japan's ratio is 365 per cent, the US is 240 per cent, while the ratio for China is 130 per cent, and Brazil is 90 per cent.

Furthermore, we have already seen corrections in global equity markets, including emerging markets, bringing markets down to even more attractive levels. In most cases, the undemanding valuations in emerging markets have already discounted the weaker earning prospects and thus a return of bargain investors could see stock prices rebound in the future.

While no one can predict the absolute bottom of a market, history has shown us that the best time to buy is when everyone is despondently selling. This enables us to pick up stocks at more appealing prices.

- The writer is Executive Chairman, Templeton Asset Management Ltd. Opinions expressed in this material are the author's at the publication date and do not constitute investment advice. They are likely to be modified without prior notice and do not necessarily represent Franklin Templeton Investments' point of view. Such opinions are provided to you incidentally. They do not constitute or form part of legal or tax advice or an offer for shares or an invitation to apply for shares of the Luxembourg-domiciled SICAV Franklin Templeton Investments Funds ("the Fund").