Why the allure of emerging markets isn't fading

Interactive Investor is 21 years old. To celebrate, our top journalists and the great and the good of the City have written a series of articles discussing what the future might hold for investors. Here's Templeton fund manager Carlos Hardenberg on emerging markets.

In many ways, it's really in the past 21 years that emerging markets have broken through as a mainstream asset allocation option for investors. During that time, those investors who took the plunge have been on a roller-coaster ride as the asset class has swung in and out of favour.

Today, sentiment appears to be at a nadir: we remain in an investment climate dominated by risk aversion, and therefore prices in general are at very large discounts in emerging markets.

But, as Sir John Templeton famously pointed out, periods of maximum pessimism often offer maximum opportunity.

We think appetite should come back in general, particularly as we don't think the large discounts on US and European prices that we're currently seeing can be justified. We expect emerging markets to continue to develop in a sustainable and positive way over coming decades.

A particularly interesting development is likely to be the transformation of some business models into companies competing more and more globally.

Twenty-one years ago, however, emerging market investing was in its nascent stage.

The birth of an investment category

The investment potential of developing markets had been recognised for a long time, but the actual birth and classification of emerging markets as an investment category was new.

MSCI developed its first emerging markets indices in 1987, and in the same year the Templeton Emerging Markets Group began managing portfolios to allow mainstream investors access to emerging markets.

It was by no means a straightforward proposition. Many developing economies in Asia, Africa, Latin America and Europe offered interesting opportunities, but very few of them were actually open to foreign investment.

Many emerging markets essentially started as exclusive clubs for the wealthy fewThere were strict foreign exchange controls and limitations, and a plethora of problems with market liquidity, corporate governance and the safekeeping of securities.

From an investment standpoint, many emerging markets essentially started as exclusive clubs for the wealthy few, but we've seen a rapid growth in egalitarian, open-market practices that today attract a wide range of global investors.

We were there at the start of many exciting developments, which included the opening of numerous markets to wider foreign investment.

A different world

In the past 21 years we've seen South Africa emerge from the dark days of apartheid, easier access to eastern European economies (including Russia), the opening up of India to foreign investment and, of course, China's embrace of capitalism and rapid urbanisation. India is a good example of how the world has changed.

Today it has a vibrant stockmarket with a vast number of listed companies, as well as a culture of entrepreneurship and investment.

However, 21 years ago it was quite different: physical share certificates and annual reporting of accounting results were the norm. Faxes were still used to place orders, and companies spent little time trying to attract investors. Corporate governance was in its infancy.

China's influence today on even highly developed markets is immenseSince then, India's corporate governance has come a long way. The financial industry at large has generally recognised India as a model of good corporate governance in the emerging markets realm, and there has been a marked increase in transparency by many listed companies.

China is the other behemoth of emerging markets. Its economy is undergoing a dramatic transformation from investment- to consumption-driven growth, and that is going to have tremendous implications for every part of its economy.

China's economic transition, along with the incredible economic growth already experienced, has resulted in a much larger economy, and its influence today on even highly developed markets is immense.

Cautious on China

In general today we are cautious on China and very selective in our stockpicking. We think the Chinese have the ability to manage their economy at this stage - they have a lot of resources and are managing their currency - but we are concerned about the banking sector in China.

We are worried about the transparency of the banks, as some of the accounting numbers we are getting are questionable. We are also concerned about the shadow banking system. We think the Chinese will be able to handle that process, but that the adjustment phase will take some time.

Generally, more youthful and growing populations mean consumer power is on the riseAs we look back at the development of emerging markets over the past two decades, it's interesting too to consider the emerging markets of tomorrow.

We expect many of these to come from the current crop of frontier markets, many of which are growing rapidly and quickly assimilating the latest technological advances, particularly in the areas of mobile finance and e-commerce.

Generally, more youthful and growing populations mean consumer power is on the rise and the middle class is growing rapidly.

However, these smaller markets are being ignored in general by global emerging market investors, partially because of liquidity problems there and partly because they are misunderstood.

There is a lot of potential in Africa, but also in some of the smaller Asian countries.

Reasons to be upbeat

Looking back over the past 21 years, we believe the welcoming of foreign capital and the trend towards privatisation have been key to the growth and development of emerging markets.

We are conscious and concerned that in some countries there is evidence that those trends could be reversed, but we remain upbeat today about the potential emerging markets offer, for three main reasons:

• Emerging markets in general have been growing three to five times faster than developed countries. Many frontier markets have seen even higher growth.

• Emerging markets generally have greater foreign reserves than most developed countries.

• Emerging markets' debt-to-gross domestic product ratios are generally much lower than those in developed markets.

Put all these strengths together, and there is good reason to be optimistic about the future for emerging and frontier markets. We are confident their share of the global investable universe will continue to grow.

Carlos Hardenberg is portfolio manager of Templeton Emerging Markets Investment Trust.

This article was first published in our special publication 21: Twenty-one years of Interactive Investor. Download your digital copy for free here.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser