Ride The Wealth Wave To Emerging Market Stocks

| About: iShares MSCI (EEM)

By Henry S. D'Auria, Ana Paula Lanzana, and Vlad Byalik

One way to win big in emerging markets is to catch the early onset of a country's wealth surge. The tipping point is often a reform-driven drop in the cost of raising capital.

Emerging market (EM) wealth creation follows an established pattern: Pro-growth reforms or improving terms of trade reduce a country's cost of capital, luring more companies to the public markets. The markets become more diverse and liquid - and more enticing to investors. In a virtuous feedback loop, rising investment inflows further reduce capital costs, spurring more public listings and even greater investor interest.

Recent examples include India, Brazil and the United Arab Emirates (UAE). Although the drivers differ, each country enjoyed spectacular growth in the scale and value of its equity market (Display) after implementing economic or capital-market reforms, in some cases bolstered by favorable export trends. We believe Argentina and Vietnam are on the cusp of such a cycle today.

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India - Reform Duo Restored Investor Confidence

The recent blossoming of India's capital markets began with the arrival of two committed reformers - Raghuram Rajan as Reserve Bank of India governor in 2013 and Narendra Modi as prime minister in April 2014. Although still a work in progress, India's promarket agenda has made noticeable strides in deregulating key sectors of the economy, simplifying the national tax code and relaxing foreign-investment rules. Since September 2013, the number of publicly listed companies has grown 11% (left Display, below), while average daily trading volume has nearly doubled, to US$3.5 billion.

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Brazil - Commodity Boom Paved The Way

Brazil's capital market growth spurt came with the China-driven commodity boom of the early to mid-2000s. It also got a nudge from new government policies aimed at spurring economic growth, taming inflation, reducing its dependence on external debt and increasing reserves. From mid-2002 through 2008, the country's capital markets exploded in size, with the number of liquid stocks rising from seven to 45 (middle Display, above) and daily trading volumes on the Bovespa increasing eight-fold, to US$1.7 billion.

UAE - Index Upgrade Marked Turning Point

The UAE's tipping point came in 2013. That year, several capital market reforms were announced in preparation of the country's entry into the MSCI Emerging Markets Index the following year. The government eased the initial public offering (IPO) process, eliminated segregated trading accounts and toughened rules governing securities lending and borrowing and mutual funds, among other reforms. From mid-2013 through 2014, the size of the country's IPOs rocketed from US$90 million to US$3.2 billion (right Display, above), while daily trading volume rose from an average of around US$50 million to a range of US$300-US$400 million.

Argentina And Vietnam - Next In Line?

So which countries look set for a similar virtuous wealth pivot? We see encouraging signs in Argentina and Vietnam. Both countries are implementing the kinds of reforms that have powered capital-market expansion in other emerging nations. Free-float market capitalizations in both markets are markedly lower than are those of the larger emerging countries (Display), suggesting significant room for development.

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Argentine president Mauricio Macri took the reins nearly a year ago, promising ambitious market-oriented policy changes. These included instituting a floating exchange rate, lifting of capital controls, and cutting energy and transport subsidies. The new administration is also looking at ways to open up the country's capital markets, potentially eliminating barriers such as withholding taxes and restrictions on currency repatriation. Companies are already starting to access the bond markets, but we expect activity in equities to accelerate as business confidence and the economy improves.

Vietnam is also slowly relaxing its capital-market regulations. In a potentially game-changing move, a year ago, the government allowed companies in some industries to lift foreign-ownership limits (while still restricting others). The change is already having an effect despite some operational hurdles. Policymakers are also looking to speed up the process of reducing the country's stake in state-owned businesses. Meanwhile, several capital-market changes are on the drawing board, including the merger of Vietnam's two stock exchanges and the introduction of derivatives by next year.

Indeed, the reform efforts in Argentina and Vietnam face stiff challenges. Argentina's Macri lacks a majority in both Houses, and is under immediate pressure to revive the economy. Despite the government's strong commitment to market reform, the pace of progress in Vietnam is likely to be very gradual, perhaps frustratingly so for some investors.

Nonetheless, we look for continued advances in both countries. New economic policies have already reduced the cost of capital in Argentina, and we anticipate the same in Vietnam. Being mindful of these opportunities and challenges can help investors identify economies that are best positioned for a surge. And within these countries, we believe investors can find many companies with strong business positions that are capable of riding the wealth wave to deliver huge payoff potential for EM investors.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.