Via Beyond Bulls & Bears, an interesting article on the state of emerging markets today:

“Almost every market move these days seems to be tied to the latest headline coming from Europe. And the U.S. political deadlock on deficit reduction, high unemployment and fear of a recession hiding under the bed are certainly not helping investor morale. But don’t throw in the towel just yet. While the ongoing turbulence in the markets has investors feeling more than a little edgy, the story of robust and resilient growth in emerging markets seems cause for optimism.

Emerging markets have been widely hailed as the next great hope, so we at Beyond Bulls & Bears decided now is a good time to reflect on historical comments and share new insights from our two emerging market luminaries, Templeton Emerging Markets Group’s Dr. Mark Mobius and Franklin Templeton Fixed Income Group’s Dr. Michael Hasenstab, who are co-portfolio managers of the recently launched Templeton Emerging Markets Balanced Fund, overseeing the fund’s equity and fixed income investments, respectively.

Many emerging markets countries have now largely shed their third world underdog reputation, as governments that initially viewed international economic development with suspicion have enacted policies favorable to growth and stable markets. Increasing demand and globalization have spurred these emerging market nations to use the proceeds from exports to strengthen their domestic economies as they assume greater roles in world trade.

Emerging Markets Today

Though 2011 has been a choppy year for emerging markets, Dr. Mark Mobius, Executive Chairman, Templeton Emerging Markets Group, notes that emerging markets have outperformed developed markets for eight of the past 10 years[1] and that the long-term outlook appears to be positive:  

“Emerging countries are forecast to grow three times faster than developed countries this year.[2] That’s reflected in the earnings of emerging market companies and the prices of those companies. There, of course, will be leads and lags in the movement of markets, but it’s clear that over the longer term, emerging markets are well positioned to potentially outperform developed countries.”

Dr. Michael Hasenstab, SVP and Co-Director, International Bond Department, Franklin TempletonFixed Income Group, suggests a steady maturing of philosophy among emerging countries has contributed to the growth of their economic power:

“For the most part, it’s apparent to the people living in emerging markets what kind of progress they have made. Perhaps the most important reason emerging markets have put in such strong performance is their adoption of free market ideology. As access to and participation in global economies increases, this correlates to improved standards of living and increased trade.”

Fundamentals for many emerging countries are comparatively strong versus those for developed countries. Many emerging nations have less leveraged banking systems, little or no budget deficits and healthy foreign exchange reserves. But such advantages don’t insulate emerging market equities from volatility in an environment where markets can move up by as much as five percent one day and down by as much the next. Still, Dr. Mobius observes that this kind of short-term volatility does not always have to be viewed in a negative light:

“Volatility is a characteristic in all markets, however, that does not mean that it is a bad thing. Taking a long-term view is the best way to cope with volatility. This enables investors to look past the short-term market movements and in fact benefit from it by investing at times when companies are oversold as a result of market panic rather than a real change in corporate fundamentals.”

Dr. Hasenstab also notes that current market volatility is not unprecedented and can be a source of good opportunity:

“As fiscal challenges in Europe have once again come to a head, the resulting volatility has created a difficult investing environment. We faced a very similar situation in 2010. While the problems faced by highly-indebted governments are real, we believe they are likely to remain primarily a European problem rather than a global one. We view these periods of heightened volatility as opportunities for us to put cash to work in some of our favorite positions at improved valuations. We encourage investors to focus on the underlying fundamentals and believe a healthy level of risk is warranted given the global economic recovery already underway.”

Views on China

While Dr. Mobius asserts that Templeton’s emerging markets investment strategy identifies opportunity on the basis of in-depth research of individual companies, rather than focusing on a particular country or sector, geographic diversification can still play a role in reining in risk by tempering the volatility of exposure to any one country’s market:  

“Generally speaking, our largest global exposures are to China, Brazil, India, Thailand, Russia, Indonesia and Turkey. I believe the BRIC (Brazil, Russia, India and China) countries are positioned to do quite well at different times. Each of these countries has unique characteristics and as such, their markets will react differently under various conditions. Outside of the BRIC markets, we think the ‘next 11? countries (Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, South Korea, Turkey and Vietnam) will be important and very interesting to watch, being a varied group with different characteristics and development stages. In addition, we are also keeping an eye on South Africa, Kazakhstan, Poland, Ukraine, Argentina, Chile and Colombia.

In terms of sectors, our focus has recently been on what we refer as the two “Cs”: consumers and commodities. Commodity stocks continue to look good because we expect the global demand for commodities to continue its long-term growth. Taking a long-term view, we expect commodity prices to trend upward due to continued demand and supply constraints. Commodities can also offer another way to access the high growth trajectory of nations like China and India and take advantage of greater demand. We generally look for companies that are strong producers of commodities such as oil, iron ore, aluminum, copper, nickel and platinum. While infrastructure development in emerging markets has led to continued demand for hard commodities, demand for soft commodities such as sugar, cocoa and select grains has also increased.”

Though recent concerns over slowing growth in China captured their share of media attention with headlines warning of everything from stagnation to a hard landing that could topple developed markets, Dr. Mobius believes these fears are unwarranted:

“Taking a long-term view, we remain positive on China. China is one of the fastest growing major economies in the world and is expected to play an important role in the global economy. With a consumer base of 1.3 billion people, consumerism has also been flourishing. With rising per capita income and strong demand for consumer goods and services, the earnings growth outlook for these companies is positive. Moreover, foreign direct investment continues to grow as international investors remain attracted to China’s booming economy. Its foreign reserves are also the largest in the world, making it less vulnerable to external financial shocks.”

Dr. Hasenstab considers that fears of China being the next big bubble are exaggerated. While he expects some slowing is in China’s future, he notes this is a natural development as the economy matures and he is confident in China’s continuing role in providing significant global growth:     

“There have been concerns that China might be about to experience a hard landing. Some observers highlight the risk that high rates of investment could result in large non-performing loans and losses in the banking sector. Others highlight the risk that past significant increases in real estate prices might be vulnerable to a sharp correction. Both risks should be monitored; however, Chinese policymakers appear to have the means and the determination to absorb potential losses in the banking sector and provide additional stimulus should the pace of economic activity weaken significantly. Moreover, recent data suggests that policymakers are being successful in cooling off overheating pressure and slowing economic growth to a sustainable and still very strong pace.”

Emerging Markets: Outlook

While there’s no such thing as a crystal ball, particularly when it comes to investing, Dr. Mobius maintains a bullish long-term outlook:

“I believe that emerging stock markets could be much larger than they are today, and in the next decade their combined value could exceed the combined value of the U.S., Japanese and European equity markets. Emerging markets have come a long way since 1986, when the International Finance Corporation started to make efforts to promote capital market development in less-developed countries. Since then, emerging countries have progressed from being simply low-cost manufacturing economies to growth-driven economies with a very strong consumer base. The importance of domestic demand in emerging countries will play an even more important role in the future as growth in developed markets is expected to be much lower. With emerging markets, growth in domestic consumption should be driven by, and hopefully sustained, in two ways: rising per capita income and, more importantly, the maturing of the young, working population who will be reaching the most productive years of their lives.”

Dr. Hasenstab concurs:

The global recovery that began last year has been characterized by pronounced differences between economies. Many emerging markets and select developed ones that were not overly reliant on leverage before the financial crisis experienced robust recoveries. These recoveries have contrasted sharply with the anemic rebounds observed in the U.S., the euro zone and Japan. We believe the multi-speed global recovery can create attractive fixed-income opportunities. We have been positioned for an environment in which emerging markets and select developed markets outperform the largest advanced economies, and we believe that this thesis remains in place.  

 On that cheery note, here’s a quote from another luminary, the late Sir John Templeton:

“Successful investing is not an easy job.  It requires an open mind, continuous study and critical judgment.”

WHAT ARE THE RISKS?

All investments involve some degree of risk. Generally, investors should be comfortable with fluctuation in the value of their investments, especially over the short term. Stocks have historically outperformed other asset classes over the long term, but they tend to fluctuate more dramatically over the shorter term. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund’s share price may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability, and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity. The risks associated with higher-yielding, lower rated securities include higher risk of default and loss of principal. The fund’s use of foreign currency techniques involve special risks, as such techniques may not achieve the anticipated benefits and/or may result in losses to the fund.