Will emerging economies stay buoyant?

Increased risk appetite drove emerging markets to make strong gains last year. But there wasn't joy everywhere - here are the best emerging markets to invest in in 2013.

When global stockmarkets have a good year, emerging markets tend to do even better. So it proved in 2012. World markets, as measured by the MSCI World Index, rose by 13%. The MSCI Emerging Markets Index gained 15%. This is because emerging-market equities are driven mainly by global risk appetite rather than local fundamentals.

If investors feel upbeat and with unprecedented amounts of printed cash around, they were very cheerful in 2012 they will buy risky assets, such as emerging-market stocks.

Another rule of thumb is that smaller emerging markets will take the top spots in the annual index performance tables. The smaller ones are thinly traded, so it doesn't take much to move them. That largely explains why Venezuela, Turkey, Egypt, Nigeria and Estonia are the year's best performers.

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Last year's winners

Venezuela's stockmarket is a "ghost market", says FAZ.net. There has been so much nationalisation in the past few years that there is barely any trading going on. Local investors have also bought stocks to hedge against a plunging local currency, the bolivar, which is threatened by president Hugo Chvez's protectionist and socialist economic policies.

What's more, adds Money.cnn.com, early in 2012 it seemed that the country's banks would be nationalised. But as Chavez's chances of re-election fell throughout the year and state ownership seemed less likely, relieved investors propelled bank stocks higher.

Turkey is a perennial favourite among emerging-market investors, thanks to its fast growth, promising demographics and large domestic market, which makes the overall economy more resilient to shocks from abroad. Credit-ratings agency Fitch, moreover, has given Turkey its first investment-grade credit rating in 20 years. That helped the market hit a record high.

Hope that Egypt was set to embark on the road to recovery after its first free presidential election was a key driver of the market's strong gains. Nigeria's 40% gain is a reflection of the sub-Saharan boom and growing investor interest in it. Growth there is humming along at over 6% a year.

Structural reform in the banking and electricity sectors bodes well. Finally, Estonia has made an impressive recovery from its "extra-severe shock" of 2009, says Stefan Wagstyl on FT.com. GDP fell by 18% in the crisis, but following a drastic austerity package and a recovery in exports, growth looks set to have hit 3% for 2012, almost double the government's initial prediction.

and losers

Equity indices in two economies greatly affected by the price of commodities, Zambia and Kazakhstan, are among the bottom five markets for 2012, highlighting the weak performance of raw materials last year. The slow pace of promised reforms in Morocco appears to have hit sentiment in the MASI Index.

Ukraine's dysfunctional politics and weak economy, meanwhile, have done nothing for local equities. Cyprus's General Market Index slumped as the island became the latest eurozone state to need a bail-out. High exposure to Greece blew a huge hole in the banking system, which in turn blew a huge hole in the government's finances.


What next?

Some of the key themes highlighted by the bottom five markets will continue to influence the outlook. Eastern Europe is the emerging region that has borne the brunt of the euro crisis as the eurozone's weak banks have cut back on lending to the region and exports to the neighbouring bloc have suffered.

In Hungary, for instance, exports to the eurozone make up 35% of GDP. With the eurozone economy falling into recession, stocks seem unlikely to start pricing in a rebound in eastern Europe any time soon.

Turkey has just reported its weakest growth in three years. And Russian stocks move in lockstep with Brent crude 72% of the time, says Ben Levisohn on Barron's. Oil supplies are not tight, and prices look more likely to fall than rise.

On the subject of commodities, key exports for many emerging markets, the outlook isn't particularly encouraging. Many raw materials are in plentiful supply while demand looks tepid. The world economy is stuck in "the twilight zone", says Morgan Stanley.

It's not collapsing indeed, a global gauge of manufacturing strength has just reached a five-month high. But it doesn't look set to embark on a strong, sustained rebound either. Europe and Japan have turned down. America looks set for at least some fiscal tightening, despite the deal over the fiscal cliff'.

China's rebound has been weak, and the authorities will be reluctant to stimulate lending much more for fear of creating yet more bad loans and blowing up the real estate bubble again.

As many emerging markets depend on exports to the rest of the world because their domestic economies have yet to hit critical mass this darkens the overall outlook. Commodity-dependent Latin America is likely to struggle and it will be difficult for Asia to achieve a strong rebound in 2013, says Morgan Stanley.

The markets we like

So the best bets are markets with large domestic economies that aren't reliant on commodities. India, thanks to recent signs that overdue reforms are being tackled, is still one of our favourite major emerging markets. Indonesia and the Philippines are our other regional favourites.

In Latin America, Mexico looks set to keep outperforming Brazil. However, given that no emerging market can escape global sentiment, and many markets have started to look pricey, investors might want to wait for the next inevitable market dip before taking another look.