The repercussions of the credit crunch are still being felt throughout the world’s stock markets and in the banking sector in particular. Major financial institutions have found a ready source of relief for their overstretched balance sheets in the sovereign investment funds that were set up by governments, mainly in Asia and the Middle East, to invest the large amounts of surplus cash being generated by their booming economies.

While this process may seem rather distant from the average investor, Phil True, head of UK institutional equities at Credit Suisse Asset Management, argues that it has major implications for the UK stock market. ‘In terms of where the sovereign wealth funds (SWFs) invest, there seems to be motivation other than diversification of the asset base and a need for higher immediate returns.’

A learning curve
True adds, ‘Many SWFs are fairly new entrants to the ex-bond investment world, and the fact that the China Investment Corporation’s (CIC’s) first investment play was to put US$3 billion (£1.5 billion) into Blackstone’s IPO may suggest that China wants access to expertise to hone its own investment skills. The hope for Western financial institutions is that they can have a reciprocal relationship and cultivate relationships within China to sell their own products and services in the country.’

True points out that ‘When the China Development Bank invested £1.5 billion in Barclays in July 2007, during the bid for ABN AMRO, the rationale centred not just on the potential investment return, but on “training and talent management”, on collaboration in commodities products and on Barclays’ input into risk management, corporate governance, and IT strategy and procurement. This is a model that is likely to become more commonplace.’

He suggests that ‘There may be opportunities to pick out some stocks in the UK market that are undervalued relative to their potential strategic importance to an SWF. But, having said that, in most cases the SWFs will be minority holders, and there will be a mixture of active and passive investors. The typical time horizon within which they need to have made a decent return may also be much longer than that for developed-world investors.’

Clearly defined strategies
True comments, ‘Looked at from a UK equity market standpoint, stakes in Standard Chartered (Temasek: 18 per cent), Barclays (China Development Bank: three per cent; Temasek: two per cent), HSBC (Dubai Investment Corporation: under three per cent) and Centrica (Petronas of Malaysia: four per cent) look like the advance platoon of a huge army. Unlike previous false dawns, the new investors from the East seem more adventurous and open to new ways of investing. They are looking for companies with at least some of the following characteristics: a decent size; a strong global franchise; the potential for intellectual property transfer; and a high emerging-market content.’
He concludes, ‘Interest in real estate could return as yields become more attractive and files are reopened on substantial UK property companies with open share registers.

The temptation to diversify into a politically stable economy in a less correlated asset at what could be good long-term value may prove hard to resist. When strong business fundamentals combine with the attributes that an SWF admires, old notions of what constitutes fair value for the stock may need to be reappraised, particularly if the company can use its new-found partners to obtain access to higher-growth opportunities.’

Going their own way
However, one of the key themes of 2007 was that emerging markets continued to provide positive returns, while developed markets disappointed, and many investors are expecting more of the same in 2008. There is a growing belief in some quarters that many emerging economies are now strong enough to ‘decouple’ from the influence of the US and, therefore, remain unaffected by any American recession.

For example, Marino Valensise, chief investment officer at Baring Asset Management, believes that investors should look to Asia for growth in 2008. He points out, ‘We are already seeing a divergence between the East and the West in terms of GDP growth. This is likely to continue in 2008, with consumer spending in the US likely to suffer dramatically as a result of resetting mortgage rates. While we are not expecting a recession yet, growth in the US is going to be much slower.

‘We are confident, however, that growth in the East will continue and that GDP growth in China is unlikely to fall below its consistent levels of eight to nine per cent annually. China’s rapid expansion and rising labour and material costs are, however, likely to result in economic activity moving to more low-cost regions in China, as well as to Asian frontier economies such as Vietnam, Cambodia and Laos. We believe that this will create exceptional growth opportunities for investors in 2008.’

Latin themes
Meanwhile, Dean Newman, head of emerging markets at Invesco Perpetual, is concentrating on the attractions of Latin America. He says, ‘We believe that there are three main investment themes in Latin America: the exciting new companies that have come into the quoted arena; the strength of domestic-demand growth; and the scope for consolidation in fragmented industries.’

He adds, ‘In particular, new companies joining the Novo Mercado in Brazil are providing opportunities in the mid-cap arena. We are playing the huge potential of domestic-demand growth through exposure to stocks in the consumer and financial sectors. Investing in utility companies also provides yield and growth opportunities.’

Newman points out that ‘Latin American equity markets have generated superior returns over the past five years compared to the more established and mature markets of the developed world. This is based on strong and positive fundamentals in the region. Economic growth, boosted by buoyant global demand and high commodity prices, continues to expand in Latin America at a healthy pace, despite the slowdown in the US economy.’

Heading for Brazil
He concludes, ‘We believe that the map of the world’s financial system is changing to become one in which Latin American markets, as an asset class, are no longer relegated to the periphery. We believe that Brazil offers many exciting and attractive opportunities for investors. Mexico is another important country that we particularly focus on. However, we also have significant exposure to some very good companies with excellent track records in Chile.

We don’t tend to invest in the fringe markets in Central America and the Caribbean, or in countries such as Venezuela and Colombia.’
Bryan Collings, manager of the Hexam Global Emerging Markets Fund, agrees that Brazil is a particularly attractive market. He says, ‘The investment case for Brazil is compelling, with strong diversified economic growth coupled with low gearing and the lowest valuation for 2008 in Latin America. Strong economic growth, an improving fiscal balance and falling interest rates promise to make Brazil the star player in the region this year.’

Collings adds, ‘With interest rates projected to fall by 100 basis points in 2008, Brazil looks more compelling than its Latin counterpart, Mexico, where economic growth is likely to be offset by the slowing growth of the US and fiscal reform. Earnings drivers in Brazil are more diversified than they have been, encompassing domestic consumption, the de-leveraging of balance sheets and rising commodity prices.’

Out of Africa
Investors seeking even newer markets are starting to turn their attention to Africa. John Mackie, manager of Standard Bank of South Africa’s Africa Equity Fund, reports that ‘We have found that emerging markets have suffered less from the US economic slowdown, and Africa even less so due to the lack of correlation with other markets.

Africa is a real growth story. We are most overweight in Banking and Financials, which currently make up 37 per cent of the fund, and we expect to see this sector grow over the year. We have seen banks and insurance companies in Nigeria, for example, which are growing their earnings between 50 per cent and 100 per cent per annum.’
He adds, ‘With Chinese demand for raw materials expected to remain robust in 2008, we see the Standard Africa Equity Fund continuing to invest in resources. We also expect to see double-digit growth in Africa’s tourist industry. One of the holdings in the fund is in New Mauritius Hotels, which had pre-tax profits up by 86 per cent in the year to 30 September 2007.’

Mackie notes that ‘The recent political unrest in Kenya has obviously caused concern and, like everyone else, we earnestly hope for a peaceful solution. But the fund only has three per cent of its holdings in Kenya and what the situation has demonstrated is the merit of diversifying investments so that we can maximise the strength of the underlying story of investing in Africa.’