2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The benchmark we use is the broad MSCI (Morgan Stanley Capital International) Emerging Markets Index; it increased by 39.4% in 2007.
Like last year, the same basic question applies: “Will the Boom Continue?” Our response is conditionally “yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets. Market volatility has increased and country allocation among the emerging market universe is critical for portfolio performance.
The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.
While the large price advances in many of the major emerging markets this year had reduced their relative attractiveness, the market drawbacks in the last few months tempered their overheated nature. China and Hong Kong are examples.
China and Hong Kong
The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.
Cumberland takes a conservative approach to participating in Chinese economic growth. We use up to eight ETFs to craft our China exposure. We will mention just two.
These two ETFs that track the shares of major Chinese firms that are listed on the Hong Kong market and/or the US market and hence meet the higher standards of these exchanges. The iShares FTSE/Xinhua China Index Fund (ticker FXI), tracks the corresponding index. It increased by 58.7% last year. The second of these ETFs, the Powershares Golden Dragon Halter USX China Fund (ticker PGJ) is comprised of the U.S. listed securities of companies that derive the majority of their revenue from the People’s Republic of China. This ETF rose by 59% last year.
The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They persist in flocking to China’s equity markets.
That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for dollar-based investors. Another importance risk facing Chinese exporters is the US presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.
On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies tracked by the two China ETFs mentioned above are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these ETFs over the course of the year. Expecting further gains in 2008, we are maintaining an overweight position in China and Hong Kong.
The heightened risks mean that it will be important to monitor developments carefully. For some recent observations and personal travel notes on China by David Kotok, see http://www.cumber.com/four-commentaries-from-trip-to-china/ .
Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong markets performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped the iShares Hong Kong ETF (ticker EWH) advance by 40.5% this past year. The leading Hong Kong companies in this ETF are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.
Singapore’s economy and market are the most advanced of the markets Cumberland includes in our Emerging Market Portfolio. Singapore has a history of sound market-based economic policies and political stability. With few natural resources other than its people and its strategic location, the Singapore economy has demonstrated consistent strong performance, responding flexibly to changes in global markets. For example, it is now the world’s second largest inter-modal port. The iShares Singapore ETF (ticker EWS) increased by 27.8% last year, just a little less than its average annual increase of 29.9% over the past five years.
The Singapore market tends to outperform in periods of increased volatility in global markets as investors seek more stable investment opportunities. High volatility promises to be a characteristic of the emerging markets in the coming year.