Robert J. Pelosky Jr. is among the most widely respected emerging markets strategists. Now managing director of global emerging markets strategy with Morgan Stanley Dean Witter in New York, he previously has been the director of Latin American research and strategy for MSDW, and was named by First Call as the most widely read analyst for Latin America in 1998.
Before joining Morgan Stanley Dean Witter, he was responsible for Latin American investment at Morgan Stanley Asset Management.
Mr. Pelosky was interviewed late last month by Brad Durham, president of Global Investor Publishing Inc., Boston.
Q: Earlier this year you had forecast that emerging markets had entered a new, multiyear investment cycle that could take the Morgan Stanley Capital International Emerging Markets Free index to 700. The index is at 399 (as of Oct. 29). Do you feel that we are still on track for EMF 700?
A: I do. I have more conviction today than when we first made the case six months ago, when the index was at 345 to 350. I feel the case for EMF 700 is still valuation, economic and earnings growth, and momentum.
That is being supported by structural shifts taking place in the investment universe, such as the recent announcement of a joint venture between MSCI and the S&P index to provide uniform industry and sector classification around the world, and the trend toward using the MSCI All-Country World (ex-US) index as a benchmark for international equity investing. That index has a 9% emerging markets weighting. This is a powerful and positive trend because it will address the desire of plan sponsors to make emerging market asset allocations to equities under an international benchmark that has emerging markets in it. Some people say that we no longer will have emerging market mandates. But my point is that there is a lot of money out there internationally, and if emerging markets can be part of the international arena (rather than a fixed strategic allocation of assets), its ability to attract that capital is increased.
Their significant outperformance this year, vis-a-vis the rest of the world excluding Japan, is increasing the focus on emerging markets. This will help get us to EMF 700. We are forecasting valuations of 14 times earnings for emerging markets next year, which compares to the rest of the world's 22 times. So value is there, and so is growth in terms of GDP and earnings. I think the trajectory of growth from 1999 to 2001 will be similar to the last time that emerging markets were in a bullish period, 1990 to '93, when the EMF was up 190% in dollar terms.
People talk about Fed fears, but I think the focus should be more on economic and earnings growth, which I think will be the key driver next year. The forecast earnings growth of 20% for emerging markets this year and 2000 may be understated. If you look at GDP growth forecasts next year in key emerging markets, it will be the best since 1996. And the analysts in their forecasts tend to underestimate the effects on earnings of economic recovery, in particular since many companies have been sold by the government and restructured by owners.
Q: What is your general outlook for the emerging markets asset class entering 2000 and what markets do you think will be the top performers next year?
A: Our view is that things look bright in the asset class. In our model portfolio, which replicates a $500 million fund, we cut the cash level Oct. 25 from 4.5% to 2.5% and added to our already overweight positions in Brazil and Mexico while going overweight Turkey. I think there will be a liquidity rally and a significant Brady bond rally. Since 80% of the Brady index is composed of Latin American instruments, it should have a significant impact on the markets in Latin America, particularly Brazil and Mexico.
I think that India is the most attractive market in Asia. The political situation looks pretty good, economic recovery continues, and companies are generating good returns. It's not particularly expensive. We have a neutral position in Korea relative to the MSCI EMF and are watching the events at Daewoo carefully. We may look to buy Korea on weakness. Overall, we are cautious on Asia and are concerned about the recent inability of companies to access capital from the equity market. Some issues have been pulled from the equity market. The recapitalization process is critical to the return of sustained high growth in Asia. The region is neutral in the portfolio. While we've been neutral all year, our thrust has been more country specific.
In the Middle East/Africa region, we like South Africa, where we have had an overweight position since earlier this year based on the view that commodities are due for a rally. South Africa also is due for a domestic economic recovery; I feel more strongly about that now than six to eight months ago.
The reasons for investing in South Africa are similar to a number of important markets. Growth in developing markets are set to be the best since 1996, while interest rates have not fallen. If you believe in low to moderate inflation, then you look for countries with high interest rates that are remnants of past problems with fiscal policy, such as Turkey, Brazil, Mexico and South Africa.
As for emerging Europe, we went overweight on Turkey Oct. 25. I think rates can come down as inflation is coming down. We have a position in Turkish T-bills (in MSDW's model emerging markets portfolio) as well as an overweight in the Turkish equity market. We also like Hungary, which we think will be a big beneficiary of foreign direct investment in Europe. One of the keys to success in the environment of low inflation is the ability of companies to produce at lower costs. We expect significant foreign direct investment flows into Hungary by European companies, similar to U.S. companies investing in Mexico. There has been a shift in financing in emerging markets from bank lending and portfolio flows toward foreign direct investment and multilateral aid, which are much more impervious to interest rate fluctuations.
Q: What are some of the fundamentals in developed markets that investors should watch for in 2000 that will have the greatest impact on emerging markets?
A: The outlook on inflation and interest rates and the Fed putting on the brakes. We've not had liquidity in emerging markets for several years. So I don't think Fed tightening will have the effect on emerging markets that people think it will have. Low liquidity is really yesterday's story.
If Japan fails to grow, that will be very important for Asia. It would create a potential risk of a slowdown.
A dramatic fall in the U.S. stock market is another risk factor. You can draw parallels between the U.S. circa 1999 and Japan circa 1989. Looking at what happened in Japan over three or four months in 1990, other major markets didn't fall. But today the correlation between the U.S. and other major markets is higher. And the conventional wisdom is to say that if the U.S. falls, everything else falls. It is a concern for emerging markets.
Q: What is the optimum scenario for emerging markets in terms of economic fundamentals in the U.S.?
A: The optimal situation would be for the U.S. market to ebb and flow, trading in a 0% to 10% range. The U.S. has been the only game in town, the place to be with the lowest risk, and this has not been lost on investors. U.S. investors have been net sellers of international exposure. Now that is shifting and U.S. outperformance appears to be over. But performance begets money, not the other way around. And with the U.S. market up 8% this year, compared to emerging markets rising 32%, we think investors increasingly will be turning to non-U.S. markets looking for performance.
Emerging markets have held up OK this year through several rate hikes. Another hurdle is Y2K, but I don't think it will be a huge event.
Q: What is your recommendation for investors between now and the end of the year?
A: We reduced the cash level to 2.5% and are predicting a powerful year-end rally. As of Oct. 29, it appeared the liquidity effect of Y2K was starting to reverse itself. We've seen it in the debt markets and I think it will spread into equity markets. I think the time frame for investing is now. A number of houses will stop trading in middle to late November until the end of the year. Market action the last couple of days shows the effects of taking out Fed risk. I still think the Fed will increase rates by 25 basis points in its upcoming meeting, but this should hold through the first quarter of 2000. People are realizing that if they wait until January to put their money to work, they won't be able to participate. So I recommend they get fully invested by the end of the year.
I also think that closed-end country, regional and global emerging market funds are very interesting. On the New York Stock Exchange many of these funds are trading at 25% to 30% discounts to NAV. I think in one to two years it is not inconceivable that some of them will be trading at a premium.
