CRISIL YOUNG THOUGHT LEADER 2013

WHICH EQUITY MARKETS DESERVE A HIGHER PREMIUM - EMERGING

MARKETS OR DEVELOPED MARKETS?





Piyush Jain
1st Year, MBA Core
NMIMS, Mumbai






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Contents

Executive Summary ................................................................................................................................................................. 3
Introduction ............................................................................................................................................................................ 4
Evolution of Emerging markets ............................................................................................................................................... 4
Why its believed to be the millennia of emerging markets?? ............................................................................................... 5
Growth Potential ................................................................................................................................................................. 5
Demographic Dividend ........................................................................................................................................................ 5
Economic Factors ................................................................................................................................................................ 6
Favorable Credit Cycle ........................................................................................................................................................ 6
Comparison of Emerging vs. Developed Markets ................................................................................................................... 7
Risk ...................................................................................................................................................................................... 7
Return on Equity (RoE) ........................................................................................................................................................ 7
Price to earnings ratio (P/E) ................................................................................................................................................ 7
Market capitalization to GDP ratio ..................................................................................................................................... 8
Sharpe Ratio ........................................................................................................................................................................ 9
Developed Markets ................................................................................................................................................................. 9
Why do developed markets then still attract capital?? .......................................................................................................... 9
Impact of recent happenings ................................................................................................................................................ 10
Conclusion ............................................................................................................................................................................. 10
Bibliography .......................................................................................................................................................................... 11
Appendix ............................................................................................................................................................................... 12




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Executive Summary

Equities as an asset class have been hot topic of discussion for decades now. Investors expects return with is
greater than risk free rate of return or higher than other asset classes such as fixed income (bonds) or cash
equivalents( money market instruments).The rate of difference between the two is called equity risk premium or
ERP. The evolution of the economies namely BRICS, MINT etc. from their status of developing to
emerging has been the most significant phenomenon of the world economy since 1990s. The sustained high
GDP growth combined with benefits of demographics has catapulted these emerging economies as a new force
in the global economy.
Among the developed and emerging markets(EM), EMs are perceived to be more risky so investors expects a
higher returns for risk compensation in these markets. In long term emerging markets have fulfilled these
expectations except few aberrations as proved statically from Sharpe ratio or Return on equity. The global and
European crisis has proved to be a boon for them to prove to the world their resilience and sound financial
systems. Emerging markets have evolved as the next big thing for the multinationals and the institutional
investors offering a sustained return on investment much higher than developed economies. Growing
importance of emerging markets can be gauged by the fact that their proportion in the world markets is
increasing in all aspects be it trade, capital markets or FIIs etc.
After so many developments and growth prospects in future for emerging markets, still, developed markets
dominate the world with around 80% of worlds capital markets. Market capitalization to GDP ratio is greater
than 1 in many developed countries while it is less than 0.5 for most of the emerging markets. Emerging
markets are still dominated by foreign players (FIIs) and thats why when FED announced QE tapering
emerging markets gave negative returns to the tune of around 27% in 2013. As of now, 15% of emerging
market household portfolios is invested in equities, compared with 42% in US households. Lack of financial
knowledge and development of other periphery services such as law firms, private equity firms etc. is another
area of concern for emerging markets.
As emerging markets are still in nascent stage, all the above problems naturally arises but growth story of
emerging markets is still very much intact with higher GDP growth, development of domestic economy, higher
savings ratio etc. These markets should continue to offer better returns (ERP) on a long term basis.



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Introduction
The modern stock markets originated from ancient Rome where money lenders traded debts between each
other and they soon began to buy government debt issues. As the business evolved, lenders began to sell debt
issues to customers-the first investors. In the 1300s, the Venetians were the pioneers in this field and started to
trade securities from other governments. Belgium had stock exchange even in 1531, in Antwerp.
The Dutch East India Company (founded in 1602) was the first joint-stock company to get listed on the stock
market i.e. on Amsterdam Exchange. The first exchange in London was officially formed in 1773 while New
York stock exchange was formed in 1792.In India, Bombay stock exchange was formed in 1875, and the oldest
stock exchange in Asia. Current market capitalization of world stock markets is around 64 Trillion USD (as per
World Federation of Exchanges) as on December, 2013, NYSE being the largest with around 18 Trillion
USD market capitalization as per WFE.
As the world economies progressed, financial markets developed progressively between nascent, developing
and mature stages. Advanced economies such G7( US, UK, Japan, Germany etc.) have markets which are
evolved, often referred as developed markets while BRICS,MINT etc. which are among the fastest
growing economies in the world. There markets are at developing stages known as developing markets.
During 1
st
decade of new millennia these economies grew at a blistering pace of around 7% leading to these
economies becoming the drivers of global growth, developing word was replaced by emerging economies.
Many global MNCs got listed in emerging stock exchanges, FIIs investment Mani folded and these markets
came to known as emerging markets. It is often said that for the long-term investor, the equity market is a
weighing machine, which anticipates economic turning points and trends rather smartly, due to the efficiency
with which new information is integrated into the price investors are willing to pay for shares. So, there came a
question with all these developments do emerging markets deserve more premium than developed markets??
Evolution of Emerging markets
The term emerging economies was coined in the early 1980s.Its members were typically the fast growing
economies with low to medium per-capita income levels that have sustained tremendous economic development
in long term, implemented significant structural reforms, and have emerged as significant players in the global
economy. Another term known as Emerging Markets emerged to signify a potential market for the future.
The scale and importance of EMs can be illustrated by Figure 1. They now represent:
86% of the worlds population
75% of land masses and resources
50% of worlds GDP ( at purchasing power parity)
In spite of all this significance and growth prospects, emerging markets are still underrepresented in investors
portfolio and make up only 12% of total global equity market capitalization on freely traded shares as of now. It
is expected to reach to 30% of global total by 2030 as per Blackrock report as shown in Figure 2
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Figure 1 Figure 2
Why its believed to be the millennia of emerging markets??
The investors in general believe that the growth potential for Emerging Markets is much more as compared to
developed markets. Its further supported by long-term demographic trends, high savings rate and low sovereign
debt ratios.
Growth Potential
In terms of economic growth, since 1992 the average global emerging market economy has grown by 116%,
versus 37% for the average G7 developed economy (source: Economist).IMF projections suggests that the same
will continue to sustain in future also.
Demographic Dividend
Positive demographic trends will be the mainstay of emerging markets growth story. Strong population growth
with rapidly rising number of working age population has provided these economies a sweet spot for future.
Figure 3 shows that the population between the ages of 15-64 is increasing in emerging economies while the
same is decreasing for developed economies. This huge pool of working population will set the foundation of
private consumption economy which will be less dependent on exports. Driver for growth in these economies
will be domestic consumption leading to these economies becoming self-reliant.


Figure 3
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Economic Factors
Generally, emerging markets have strong balance sheets. Due to this strong financials they have emerged
successful post 2008 sub-prime and euro crisis. Banking sector in emerging markets are still strong and giving
credit for growth stimulus and not suffering from lending constraints while the banking institutions in the
developed economies are looking out for bail from their governments like Greece, Ireland (Eurozone) etc. Also,
Debt to GDP ratios (as shown in Figure 4) in emerging economies is low placing them at a better position to
face any untoward crisis in future.
Figure 4
Favorable Credit Cycle
Domestic debt levels in these markets are low coupled with higher savings rate (developing economies have
approx. 30% saving rate) as shown in Figure 5 and low banking penetration provides a platform for credit
growth which in turn will boast domestic spending thus driving demand leading to economic expansion in
emerging economies.
Figure 5
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Comparison of Emerging vs. Developed Markets

Risk
Typically risks associated with emerging equity markets are higher than that of developed markets. Also, Betas
of EMs are higher than developed markets which means that EMs are more volatile. For example, Figure 6
shows the 3-year rolling volatility of emerging market and developed market equities. Emerging equity
volatility has been consistently higher.


Return on Equity (RoE)
Emerging markets offer better RoE as compared to developed markets as shown in Figure7.In future also
emerging markets are poised at an advantage due to structural reforms in various sectors, increase in FDI limit,
ease of labor and capital, better transport infrastructure.

Figure 7
Price to earnings ratio (P/E)
Emerging markets are trading at a discount relative to developed markets from the early 2000s and their own
long term average which means that they are relative cheap as compared to investing in developed markets as of
Figure 6
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now as per Figure 8 and as more than 50% of the global corporate growth, the role of the emerging economies
have now become a key consideration for all investors. Over a long period of time both the markets will
converge

Figure 8
Market capitalization to GDP ratio
Economic development is reflected in the proportion of the economy that is reflected in the stock market. What
reflects this dimension is the ratio of country market capitalization to GDP. Empirically, as shown in Figure 9,
advanced financial markets tend to have market capitalization/GDP ratios that are closer to 100%. In contrast,
stock markets in China, India, and Russia capture only a small portion of the economy. Emerging market
companies make of up 26%5 of global equity market cap while emerging markets represent 36% of global GDP
(compared to 19% twenty years ago) so still a lot of gap still exists between GDP and equity market
capitalization.

Figure 9
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Sharpe Ratio
Though Emerging markets have been an excellent long-term buy and hold investment, they have not always
compensated for their higher risk. In fact, the Sharpe ratio of the investment is fairly volatile and prone to
extreme swings as shown in Figure 10. But, this additional risk was primarily concentrated in the crisis years
pre-2002. Since then, the risk-adjusted return of investing in emerging markets has been consistently higher.

Figure 10
Developed Markets
After all the discussion on Emerging markets vs. developed markets lets do a reality check: NYSE has market
capitalization of around 18 trillion USD while Shanghai still lags at around 2.3 trillion USD (Dec 2011). Even
though, Hong Kong has emerged as a regional hub for many international companies but still only 23
international companies are listed in Hong Kong stock exchange while more than 590 companies are listed in
London stock exchange( Dec 2011). International financial centers, such as New York and London, benefit
from huge institutional liquidity, and the kind of infrastructure and pools of human capital built over a long
period of time. These characteristics have given them significant advantage over EMs and its difficult to
replicate the kind of organic depth they have achieved.

Why do developed markets then still attract capital??
Liquidity is the most important characteristics of developed markets which still have more than 80% of worlds
equities market capitalization benefitting from deep pool of local and international capital.UK, has US$6.5trn in
assets under management, representing 8.2% of global funds, while the US, has a huge US$35.6trn in assets (or
44.9% of global funds) under management. The broader financial services infrastructuresuch as investment
banks analysts and sales and trading operations, law firms, institutional investors and the private equity
industry are well developed in developed markets, such as New York and London.

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Impact of recent happenings
Year 2013 was a challenging one for emerging markets equities declining 2.3%, as measured by the MSCI
Emerging market Index (EM index), in the US dollar terms; on the other hand developed markets gained 27%
in US dollar terms as measured by the MSCI World Index. This performance differential has been matched or
exceeded only 3 times in the history of the EM Index most recently in 1998 during the Russian debt crisis. This
is an interesting comparison, as this underperformance is not related to any specific crisis in the emerging
markets. Rather, it reflects the abundance of easy credit in developed markets due to ongoing quantitative
easing in Europe and the United States, as well as the drag on emerging markets as a result of current account
deterioration (CAD).
Still, emerging economies fundamentals remain strong on 2 counts namely a) large Forex reserves b) low levels
of sovereign debts as compared to developed market countries.Altough, current account deficit in emerging
economies possesses a serious threat on economic balance of these countries resulting in stagflation( high
inflation and low growth). But recently various corrective measures by central banks of emerging economies
and floating-rate currencies have given some reliefs to them. India is one such example. As credit tightens,
domestic consumption will shrinks and imports decelerate more quickly than exports as happenings in India.
Thus, the current account could improve, creating a stabilizing effect on the rupee and, subsequently, inflation.
This would grant RBI room to maneuver on the policy front. In addition, as developed-market growth improves
(as happening in US with GDP growth around 3%) and emerging-market currencies remain weak, current
account deficits in the developing world could benefit from resurgence in exports. This is already visible in
Indias case as CAD has reduced to 1.2% from high of 4.8%.
Conclusion
The statistics are in support of the fact that the emerging markets are going to reshape a new world order in the
next decade or so. The emergence of the emerging markets as the favored place for investors post the global
and the EU crises offering better ERP has been established however there are still many issues which cast
shadow on the sustainability of these markets as a dream destination. The central banks and the policymakers
in the emerging markets face real challenge in protecting their economies from reversal of capital flows, the
FIIs which are very high due to the high interest rate differentials. High proportion of capital inflows in equity
markets expose these markets to global shocks in the world market and could magnify domestic policy
conundrums. They need to develop their local capital markets on account of better infrastructure and domestic
consumption by increasing the proportion of savings in markets to reduce their vulnerability to the above
elucidated problem. The excessive control on the capital markets of such economies by the foreign institutional
players must be reduced and for this to happen the government must focus on the promotion of capital market
development. Further, there is a greater need to enhance the financial literacy of their local population. Political
risk will likely take emerge in 2014, with various elections at the presidential, parliamentary, and local levels
due to take place across the emerging markets, including India, Thailand, Turkey, South Africa, Indonesia, and
Brazil. Many of the future political leaders are reform-minded which, depending on the election outcome, could
provide a catalyst for change in the investment environment and truly fulfilling the potential of these markets.
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Bibliography
Salomons, Roelof and Grootveld, Henk, The Equity Risk Premium: Emerging versus Developed Markets (August
7, 2002).
Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2013 Edition
(March 23, 2013).
http://www.economist.com/blogs/buttonwood/2014/01/markets
http://epfr.com/
http://www.world-exchanges.org/statistics/monthly-reports
http://www.msci.com/products/indices/size/standard/index_review.html
http://www.world-exchanges.org/files/statistics/2012%20WFE%20Market%20Highlights.pdf
http://www.blackrock.es/content/groups/uksite/documents/literature/1111106088.pdf
http://www.pwc.de/de_DE/de/kapitalmarktorientierte-
unternehmen/assets/Capital_Markets_in_2025__web.pdf
http://www.lazardnet.com/docs/sp0/145/LazardOutlook_EmergingMarkets_2014Q1.pdf














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Appendix

EMs- Emerging Markets
ERP-Equity Risk Premium
CAD-Current Account Deficit
BRICS-Group of nations of Brazil, Russia, India, China, South Africa
MINT-Group of nations of Mexico, Indonesia, Nigeria, Turkey
FII-Foreign Institutional Investors
MNC-Multinational Companies
GDP-Gross Domestic Product
FDI- Foreign Direct Investment
MSCI-Morgan Stanley Capital International