Domestic demand and commodities to drive emerging shares

Emerging market equities, supported by improved fundamentals and firmer commodity prices, should build on out-performance this year to thrive in 2010, while developed markets will struggle with anaemic growth.

Traditionally emerging markets shares have lagged behind in periods of global recovery but efforts to beef up currency reserves and narrow fiscal deficits means that this time around they have rebounded faster.

The MSCI emerging markets equities index has jumped 71 percent this year compared to a 30.6 percent gain for global equities.

Chinese stocks, benefiting from strong domestic demand, and Brazilian and Russian equities that will derive support from firmer commodity prices, will be particularly well-placed, investors said.

Jane Davies, senior portfolio manager, World Selection fund at HSBC, said struggling labour markets and high debt levels would hinder developed economies in 2010.

"In emerging markets we certainly see much healthier economic fundamentals, lower debt levels overall and on the macro-economic side emerging markets will be the brightest prospects for growth next year."

China's GDP is forecast by the OECD to grow 10.2 percent in 2010 compared to the OECD total of 2.1 percent.

SHORT-TERM ANXIETY 

Some major emerging economies recently imposed capital controls, prompting some investor anxiety, but analysts said the measures' limited scope and the economies' underlying strength mean the long-term impact is likely to be small.

Capital controls imposed by countries including Brazil, Russia and South Korea are seen as having the potential to damage sentiment and performance of emerging markets. Click on for an ANALYSIS on this subject.

"In the short term (the measures) create market volatility, and they are not investor friendly actions, but in the medium term we don't think they hurt the investment case" said Davies.

Historically, developed markets have traded at a premium to emerging markets especially during the period 1995-2007.

In October 2000, the 12-month forward price earnings ratio was 23.9 for developed markets compared with 12.0 for emerging markets, according to Thomson Reuters data.

But the gap has since narrowed and they trade at 14.5 times earnings, compared to 13 times for emerging markets, and this could narrow further and even reverse as emerging economies look increasingly robust.

Morgan Stanley favours consumer discretionary stocks and financials and is overweight Brazil and China.

Michael Wang, emerging market strategist at the bank cited Chinese Internet firm Tencent Holdings, oil and gas producer CNOOK, Taiwanese tech stock Mediatek and Indian energy firm Reliance Industries as examples of companies set to thrive.

ENERGY BOOST 

Optimism that commodity prices will remain firm should help boost some emerging markets, investors said.

"We rotated into energy" said Steven Bell, portfolio manager and director at hedge fund GLC. "We have a much more bullish view on oil prices than the street does and that's part of the reason why we are overweight in Russia."

But the resilience of domestic markets in emerging economies is also a factor supporting investor confidence.

"We also like some of the domestic-facing sectors like consumer discretionary and financials, particularly in countries with a strong domestic recovery and low credit penetration such as China" Bell said.

But some investors are more cautious, saying much of the improved strength of emerging markets has been priced in, and that it pays to focus on specific markets where there is room for further out-performance.

Davies at HSBC says current valuations mean it is taking a neutral stance on emerging versus developed markets, but sees Latin American markets as likely to thrive.

"One of our key stances is an overweight position in Latin America to emerging Asia on valuation grounds. (It has a) 40 percent discount using trailing PE levels."