Emerging Markets: The More 'Uncoupled', the Better

by: Gary Smith

There's to be no resting on one's laurels in the emerging markets, according to Grantham, Mayo Van Otterloo [GMO]. The emerging markets had another excellent year in 2007 (returning in excess of 35% for the fourth year running as an asset class), GMO reported in its Quarterly Update for the fourth quarter of 2007, and this despite the turmoil and the pervasive nature of the U.S.'s subprime crisis. However:

Current valuations in emerging markets are now at parity, if not at a slight premium, to the developed markets. Barring the formation of a bubble in emerging markets, P/E ratios are unlikely to expand much from the current level. Similarly, while moderate currency appreciation is possible, its contribution to total return is likely to be modest. Current earnings growth forecasts for the asset class are around 18%, but we view such estimates as optimistic, especially in light of a likely slowdown in the U.S. The first quarter of 2008 is also likely to be fairly volatile as the wide-ranging effects of the credit contraction in the Western world plays itself out and the impact of a weakening U.S. economy reverberates through the global economic system. We believe emerging markets will emerge fundamentally unscathed, if not untouched, by the current turmoil due in part to the fact that emerging markets are for the most part net creditors in global financial markets and in part because of the strength of their domestic consumption and investment story. From a relative standpoint, we are increasing our positions in countries with a stronger domestic component like India, China, Indonesia, and Russia, while we are decreasing our positions in countries more correlated to the U.S. economy like Korea, Taiwan, and Mexico.

...Entering the first quarter of 2008, the Emerging Country Debt Strategy is overweight Ukraine, Argentina, Colombia, and Russia. The largest underweights are Lebanon and Malaysia. We believe wider spreads at yearend create opportunities for our bottom-up security selection strategy.