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Hedge Fund Monthly
 

Emerging Markets and the World of Tomorrow

Karthik Sankaran, Managing Principal
Covepoint Capital Advisors LLC
October 2011
 

The last few years have seen an upsurge of interest in the theme of the so-called “emerging markets” (EM). For most of the past decade, sentiment towards EM has been generally bullish, but there are moments when perceived excessive euphoria leads to talk of “bubbles” and the like. This happened to some degree ahead of the first Fed rate hike in 2004, and it happened much more dramatically in the aftermath of the global financial crisis of 2008.

This year, the combination of unrest in the Middle East and worries about the impact of commodity price-driven inflation have led to the underperformance of EM versus developed markets (DM) amid renewed talk of bubbles. Now, while it is only natural for asset managers to focus on asset prices, focus must instead be on the tectonic shifts that have occurred in the world over the last decade. These epochal changes underpin the importance of EM to the global economy and global investment strategies.

The single undeniable fact about EM is that they already account for a significant portion of the world economy. According to the World Bank, as of the end of 2009, all EM accounted for about 38% of global GDP as measured at current nominal exchange rates. That percentage is probably closer to 40% by now. However, when considered by Purchasing Power Parity (PPP), the share of GDP by EM is even larger. As of October 2010, the IMF put the emerging markets share of global output at 50% at PPP. (In keeping with the convention of FX markets, the newly industrialised Asian economies will be considered, including Korea, Taiwan and Singapore, to be EM countries.)

There are two obvious conclusions from this. The first is that an investment strategy that is focused solely on the developing markets makes about as much sense as an advertising strategy for toothpaste that is focused only on one sex. It might do for a niche producer, but not for anyone with a genuinely global vision. The second point is that we, as foreign exchange traders, tend to be wary of PPP as a trading tool. Nevertheless, we believe that the 10% spread between the global weight of EM as measured in PPP terms and in current dollar terms will close over time – in other words, that emerging markets currencies as a group will outperform.

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