Emerging markets such as Brazil and India have not performed strongly over the past year, but are perceived to have inherent resilience and do not just depend on the US economy for their growth, writes Fiona Reddan

AS EQUITY markets in developed countries across the world continue to plunge in the wake of last year's credit crisis, is it time to look further afield for investment returns?

Over the past 10 years, emerging market economies such as Brazil, China, India and Russia have grown to such a scale that collectively they are now bigger than the US and European economies, and last year accounted for 60 per cent of global growth.

Traditionally, emerging markets exhibited a strong correlation with equity markets in developed countries, but Jeff Chowdry, head of emerging markets with Friends First's asset management arm, FC Asset Management Ltd, says this is changing.

"It used to be that when developed markets fell, emerging markets fell further, and when developed markets rose, emerging markets tended to go up more," Chowdry says.

"That was the case up until about 2002, but that correlation has broken down in the last five years, as people have realised such markets have strength of their own and don't just depend on the US economy for their growth."

He adds that he expects this correlation to continue to fall.

Nevertheless, performance has been poor, as emerging markets have returned less over the past year than developed markets.

Ahead of the credit crunch of 2007, emerging markets performed very strongly, buoyed by rising oil and commodity prices. Now, however, oil has significantly dropped back from its peak, hitting countries such as Russia, and the commodity bubble has started to burst, which has particularly affected big commodity exporters such as the Latin American markets.

Moreover, as a result of strong growth in emerging market economies over the past number of years, interest rates have risen as inflationary pressures continue to soar.

In Brazil, interest rates are among the highest in the world, at about 13 per cent, while inflation is at 6 per cent.

Overall, emerging markets are down by about 25 per cent this year, while the worst-hit markets include the Ukraine, which has fallen by almost 60 per cent this year; China, which is down 57 per cent due to fears of a bubble; and Russia, which is down 46 per cent since its May 19th peak.

The Brazilian market has fallen by about 20 per cent, and India is down by about 30 per cent for the year to date.

For investors, emerging markets are riskier than developed countries. "The political risk is higher and you may get individual countries doing silly things on an individual basis," says Chowdry, citing Russia's recent activities in Georgia. "The other risk is that stock markets are relatively immature with less developed corporate governance structures, but the major risk factor going forward is probably the external environment, and in particular, the US economy."

One trend currently affecting emerging market funds is the "flight to safety" of investors, both institutional and retail, out of riskier equity funds to safer investments such as bond and cash funds. According to data provider EPFR Global, over the past three months, outflows from emerging markets bond and equity funds reached $29.5 billion (€ 20.9 billion), the highest level since at least 1995, and withdrawals continue to gather pace.

However, Chowdry says that this "panic" selling is leading to a great buying opportunity.

"I don't believe where we are today is any different from other crises such as the Mexican crisis, the Russian crisis or 9/11. These were all periods when markets fell in the short term, but subsequently proved to be great buying opportunities, and I believe that we're currently in one of those great buying periods now."

He cites factors such as a levelling off in inflation as being behind the next wave of growth. "As inflation peaks, we expect interest rates to come down," he says, adding that he favours the Brazilian and Indian markets.

"Brazil is one of the cheapest markets in the world, with some of the highest earnings growth."

Although India has been one of the worst-performing markets in the world so far in 2008, down by about 30 per cent in the year to date (not as bad as the Iseq, though, down almost 40 per cent), Chowdry believes it's close to bottoming out.

"India is a very big importer, so when oil prices went through the roof in the first half of the year, the market suffered as inflation rose, interest rates rose and corporate earnings suffered. However, the story on India today is as oil falls it will kick in significantly in terms of corporate earnings.

"The other thing we like about India is that it is very much a domestic demand story in the sense that the growth in the economy is being led by local demand, local consumers, local industry, rather than exporting to the US or developed countries."

In fact, this domestic demand aspect is common to many of the larger emerging markets. In China, for example, just 13 per cent of its GDP is linked directly to exports, while the rest is linked to domestic demand.

Another factor which will drive growth is demographics and rising populations. India has the fastest-growing working population, while growth of working population has stalled in developed markets. Moreover, mortgage penetration in emerging markets is low, which presents scope for banks and other industries involved in the construction sector.

Moreover, the increasing level of domestic investment in emerging markets is having a stabilising effect on markets, with domestic investors less likely to pull out their money in the event of a shock.

Looking ahead, Chowdry says that emerging markets are either at the bottom, or are very close to the bottom. In particular he expects Brazil and India, which have significant domestic demand, to outperform developed markets.

"Where we're more cautious is where exports are a very big proportion of GDP - in Korea and Taiwan, for example," he says.

He is also less optimistic about the outlook for both China and Russia. "A rebound in the Chinese market is dependent on whether the Chinese authorities can engineer a soft landing for the economy. We're not certain that they'll be able to do that," he says.

In the case of Russia, Chowdry says political risk remains high and corporate governance is pretty poor, but he adds that this is offset by the fact that it is the cheapest market in the world, with very high earnings growth.

However, Tim Brown, a director with Jewson Associates, strikes a note of caution for investors looking to emerging economies and says that given the current volatility of global markets, "it's probably too soon to make any major commitment to emerging markets".

"I think it will still be a while before emerging markets start to outperform developed markets," he says, adding that the current turmoil is causing investors to be increasingly risk averse.

In addition, Brown says that the credit crunch has actually increased the correlation between developed and emerging markets.

"While at one stage the markets behaved differently, the latest turmoil has created price falls across the board and, in some cases, the price falls have been deeper in emerging markets, even though you would have expected them to be less exposed."