Emerging markets (%)

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October 2010

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Emerging markets offer compelling long-term return potential, but continue to present risks that every investor should understand.

In this paper, Richard Titherington, CIO of the Emerging Markets Equity Team at J.P. Morgan Asset Management, discusses the risks inherent to emerging markets and looks at the effect they have had on economic and investment performance. He also explains why globalisation and urbanisation mean that, for long-term investors who are aware of the risks, there is considerable reason for optimism about emerging markets.

I believe in the long-term outperformance of emerging market equities as an asset class: if I didn’t, I wouldn’t be working as head of J.P. Morgan Asset Management’s Emerging Markets Equity team. However, it is important for us and our clients to understand the risks inherent in the asset class.

The Fundamentals Driving Emerging Market Equities

First, it is worth restating the two fundamentals driving the development of the emerging market asset class.

The first is the rebalancing of the world economy from the extreme of concentration of economic power typified by the creation of the G7 (the group of seven industria- lised nations) in 1976, which meant that by the end of the Cold War in the early 1990s the developed world of North America, western Europe, Japan and Australasia, approximately 12% of the world’s population, represented 77% of global GDP. It is this extreme degree of economic imbalance that is unusual, not the more balanced world we are moving back towards.

authOr

Richard Titherington Managing Director Chief Investment Officer

Head of the Emerging Markets Equity Team

1820 66.0

1913 19.1

5.5

41.8 33.6

Today 21.2

11.6

19.1 48.1

North America (%) Developed Asia (%) Europe (%) Emerging markets (%)

1.8 3.4

28.8

exhIbIt 1: the really bIg PIcture

emergIng markets’ rIsIng share OF glObal gDP

Source: J.P. Morgan Asset Management, Angus Maddeson 2001, IMF as at end 2009, GDP in PPP terms

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Emerging Markets

The second key driver is urbanisation—the continuing move of population from the countryside to cities—which drives both productivity and consumption. Approximately 50% of the world’s 6.8 billion people currently live in urban areas.

However, more than 95% of the population of developed countries are already based in urban areas. In consequence, close to 100% of the productivity and consumption growth derived from urbanisation lies in the emerging world, sustain- ing faster economic growth.

Strategic Risks to Monitor

Having described the key positive drivers, let us look at the risks, and specifically at why many of the emerging nations of 100 years ago are still emerging today. There are two key rea- sons: revolution and inflation. The chart below lists the ten largest emerging markets and highlights their experience with these two destructive phenomena.

The economic consequences of political revolution are clear, with the Russian and Chinese examples of the twentieth century not requiring further elaboration. Many countries in the emerging world have witnessed less well known but equally damaging political upheavals, which make political and legal institutions less reliable and predictable than in the developed world.

The impact of inflation is less obvious but more pernicious in preventing development and especially in perpetuating pov- erty. Over the last 100 years, Brazil has grown on average at 4.9% in real terms. This is considerably better than the USA, which grew at 3.5% over the same period.

However, Brazil remains an emerging market, while the USA is the world’s leading economy. Unlike most of the top ten emerging market countries, Brazil, despite periods of military rule, has not suffered from political revolutions, partition or war. Consequently, it should be a candidate for graduation from emerging to developed status.

the equivalent of half the population of europe moving from the countryside to the city.

0 10 20 30 40 50 60 70 80 90

1950 1970 1990 2010 2030 2050

0 50 100 150 200 250 300 350 400 450 500 Emerging regions—rural population

Emerging regions—urban population

Total change from prior five-year period—urban population

Million people

Percent

Source: World Bank Data. Data as at January 2008. For illustrative purposes only.

exhIbIt 2: urbanIsatIOn—the bIg mOve

350m PeOPle FOrecast tO mOve FrOm rural tO urban lOcatIOns between 2010 anD 2015

Proportion of the mscI all-countries

world Index (%) revolution Inflation

China 2.47 1911, 1937–1949 1990–1995

Brazil 2.14 1979–1993

Korea 1.80 1910, 1945, 1950–1953 1998

Taiwan 1.45 1911, 1949

India 1.08 1947

Russia 0.84 1917–1922, 1991

Mexico 0.57 1910 1980–1988

Malaysia 0.41 1963–1965

Indonesia 0.31 1945–1949 1998

Chile 0.24 1973 1970–1975

Turkey 0.24 1918–1923 1973–2004

Thailand 0.22 1998

Total 11.76

Source: MSCI, World Bank, IMF, CIA World Factbook, September 2010.

exhIbIt 3: ten largest emergIng markets revOlutIOn anD InFlatIOn

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come in the last eight years. It is this change from high to low inflation that has allowed the Brazilian market to return 16%

per annum since 1995: twice the return per annum of U.S.

equities over the same period.

Inflation increases inequality, impoverishing the majority of the population. It also undermines currency values, explaining why for most of the last 100 years emerging market currencies have been weak against G7 currencies. In consequence, the biggest financial risk we face as investors in emerging markets is a return to an environment of fixed exchange rates and high and rising inflation. We expect average inflation in the emerging world to be 5.5% over the next five years, based on our internal macroeconomic work. If that assumption is correct then, except for individual countries such as Venezuela, the inflation risk in emerging markets is low and on a completely different scale to that experienced in the period from 1970 to 2000.

Therefore the two strategic risks that we need to understand and monitor are political upheaval, which leads to the appropri- ation of assets via revolution as in Russia, China, Turkey, Egypt, Chile, Cuba, Iran, Algeria and Vietnam, among others, and inflation, which destroys the real value of assets, as seen in Argentina, Brazil, Zimbabwe, Russia and Indonesia. Political risk need not be as dramatic as some of the revolutionary examples given, but may involve an undermining of the rule of law and a pervasive culture of bureaucratic and corporate corruption that siphons wealth from shareholders to domestic power brokers.

As such, we should broaden our monitoring of political risk to governance in general rather than just revolution.

0 10 20 30 40 50 60 70

1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979

Percent

0 500 1,000 1,500 2,000 2,500 3,000

1979 1982 1985 1988 1991 1994

Percent

exhIbIt 5: brazIl InFlatIOn 1979–1994

-5 0 5 10 15 20 25 30

1995 1997 1999 2001 2003 2005 2007 2009

Percent

exhIbIt 6: brazIl InFlatIOn 1994–2009

Source: J.P. Morgan Asset Management.

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Emerging Markets

On an earnings and asset basis, emerging market equities also appear to be trading close to long-term averages.

The great difference between bonds and equities is that the former trade on perceptions of solvency, the latter on perceptions of future profitability. Valuation is therefore not a con- cern on a tactical basis as long as market expectations for earnings and dividend growth are not unrealistic.

Tactical Issues

Alongside the two strategic risks are the two tactical issues that should inform any equity investment, emerging or developed: earnings and valuation.

Over the last ten years, emerging market debt has re-rated, reflecting a dramatic improvement in credit quality as the asset class approaches investment grade. Equities, in contrast, trade at levels similar to those of a decade ago, meaning emerging market equities currently appear cheap against emerging market debt.

0 5 10 15 20

Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 EM bond yields ¹

EM equity yields (forward) (E/P)

emerging market equities look cheap relative to emerging market debt.

exhIbIt 7: cOmParIng emergIng market equIty anD bOnD yIelDs emergIng market earnIngs anD bOnD yIelDs, 1991–august 2010

1 Re-weighted bond yields with equity weightings to make these two yields comparable.

Source: J.P. Morgan Asset Management, Factset, Bloomberg, Data as at end August 2010.

-10 -8 -6 -4 -2 0 2 4 6 8

exhIbIt 8: cOmParIng emergIng market equIty anD bOnD yIelDs emergIng market equItIes relatIve tO Debt, 1991–august 2010

asset multIPles are hOverIng near lOng-term averages;

earnIngs multIPles have Fallen back belOw average exhIbIts 9: valuatIOns

gem PrIce tO bOOk: 1993 tO august 2010t 2 0 1 0

0 200 400 600 800 1,000 1,200 1,400 1,600

Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 MSCI EM 4.0

MSCI EM long-term average P/B MSCI EM P/B (RHS)

exhIbIts 10: valuatIOns

gem PrIce tO FOrwarD earnIngs: 1993 tO august 2010

5 7 9 11 13 15 17 19 21 23 25

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

MSCI EM Fwd PE Rolling Average +/- 1 sd

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enjoyed by shareholders rather than the GDP growth that most commentators focus on. The Emerging Markets Equity Team at J.P. Morgan Asset Management currently expects average earnings per share growth for the companies we cover to be over 15% per annum for the next five years. If this expectation is right then the combination of earnings per share growth at twice the global level, modest currency appre- ciation and a current dividend yield of 2.5% (likely to grow at 12% per annum) should give investors an attractive return from these levels over the next five years.

0 10 20 30 40 50 60 70 80 90 100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

USD per share

0.2%

29.9%

exhIbIt 11: gem earnIngs Per share grOwth

Source: MSCI, J.P. Morgan Asset Management, 2010/11 J.P. Morgan Asset Management estimates.

-30 -20 -10 0 10 20

1992 1995 1998 2001 2004 2007 2010E

Percent

Source: MSCI, IBES, Morgan Stanley as at May 2010, GEM universe. E = MS estimate.

Dons Disc

cons

staples Financials

Info

tech telecoms

2006 2.2 39.7 11.3 13.1 19.3

2007 5.5 16.6 33.4 35.0 47.5

2008 -12.6 10.0 5.6 27.4 -3.6

2009E 16.4 -0.9 -3.3 -33.9 9.0

2010E 14.9 15.0 21.1 14.0 17.2

2011E 15.0 16.5 26.6 27.8 0.6

exhIbIt 13 – DIvIDenD grOwth OF key sectOrs (% P.a.)

Source: UBS as at 28 February 2010.

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Emerging markets

Conclusion

The emerging markets story is by no means without risk, including the strategic risks of governance and inflation and tactical risks around earnings growth and valuation. Our current view on these risks is summarised in the table below.

gOvernance rIsk Low at the national level among the larger countries.

Ever present at the stock level, although rising average ROE suggests a positive trend.

InFlatIOn

Low by historical standards but cyclical pressure is upwards.

Currency flexibility and economic orthodoxy are key to continued success.

valuatIOn

In line with historic averages, although high relative to developed markets.

Wide company and sector variance makes stock selection crucial.

earnIngs

A strong cyclical recovery is being followed by robust secular growth.

Reduced dependence on G7 trade gives greater confidence in the sustainability of EPS and DPS growth rates.

s t r a t e g I c

t a c t I c a l

However, for investors who are comfortable with these risks, we believe there is considerable reason for optimism around emerging markets, driven by global rebalancing and by the long-term urbanisation trend, which is spurring dramatic improvements in productivity and consumption.

emergIng markets OFFer a cOmbInatIOn OF:

Attractive growth and dividends

•

Maturing growth and rising dividends

•

FOur key sectOrs

Consumer (discretionary and staples)

•

Financials

•

Information technology

•

Telecommunication services

•

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employee since 1986, Richard transferred to the Pacific Regional Group in 1994. He was appointed as a managing director in April 2001 and appointed head of the global emerging markets busi- ness in December 2001. Prior to 1994 Richard was a US and international pension fund manager, working in the UK until he transferred to Hong Kong in 1992. Before joining the firm, Richard spent two years as an analyst with UKPI in London. Richard obtained an M.A. in politics, philosophy and economics from Oxford University.

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Emerging markets

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This material is intended to report solely on the investment strategies and opportunities identified by JPMorgan Asset Management. Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. JPMorgan Asset Management and/or its affiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors; if you have any doubts you should consult your JPMorgan Asset Management Client Adviser, Broker or Portfolio Manager. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. You should consult your tax or legal adviser about the issues discussed herein. The investments discussed may fluctuate in price or value. Investors may get back less than they invested. Changes in rates of exchange may have an adverse effect on the value, price or income of investments.

The risk of investing in foreign countries is heightened when investing in emerging markets. In addition, the small size of securities markets and the low trading volume may lead to a lack of liquidity, which leads to increased volatility. Also, emerging markets may not provide adequate legal protection for private or foreign investment or private property.

International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations.