Derivatives could threaten emerging-market growth, says Mobius

If anything is going to derail the recovery in emerging markets, it's most likely to be restrictions on world trade and/or potential problems posed by derivatives contracts, says emerging-markets guru Mark Mobius.

"Any restrictions on world trade, such as those imposed by the US, could cause problems for emerging countries," says Mobius, executive chairman of Templeton Asset Management in Singapore.

As for derivatives, the danger is that they could cause another global crisis, he adds. "Companies in emerging markets are being sold derivatives aggressively -- and that presents a problem," says Mobius. "There have been no reforms in terms of transparency regarding these instruments, and there continues to be a lack of transparency and liquidity in this area."

He argues that the lack of transparency comes down to the fact that many such contracts are too complex for companies to understand, while the lack of liquidity is due to the fact that such instruments often are not tradable on exchanges.

"The derivatives market is alive and well and is now $600 trillion in size, and therefore 10 times the size of total global gross national product," adds Mobius. "Derivatives multiply capital. They give people an impression of control, which in turn encourages them to take more risk. That also creates a surge in liquidity in emerging markets and globally."

Hence, Mobius says he would favour increased standardisation, simplification and listing of derivatives contracts.

Yet there remain very good reasons to invest in emerging markets, he says. For one thing, such countries have learned a number of things since the 1998 crisis. "The main lesson was not to get too heavily in debt, especially in foreign currencies you're not earning," says Mobius. As a result, emerging markets have been building up reserves at a country and corporate level. Another thing they have learned is to keep inflation and interest rates low, although such an environment can eventually lead to excess liquidity and speculation.

Moreover, emerging markets are growing four times faster than developed countries, he adds, and have lower debt-to-GDP ratios than developed countries.

So it is not surprising that emerging-market stocks have outperformed developed-market stocks by a wide margin. But Mobius says relative growth in emerging markets will inevitably slow down, because they won't be rising from as low a base as before.

"We must be ready for a slower increase, but nevertheless growth could be quite substantial," he says. "Low interest rates mean that we may see a lot of companies with good earnings that compare favourably with their own history and with those in developed markets."

With regard to specific emerging-market investments, Mobius favours the commodity and consumer sectors. Commodity prices will continue their upward trend, albeit with significant volatility, he says. He notes that the MSCI emerging-market materials sector index -- which includes companies producing commodities such as iron ore -- rose by 108% in the year to December 31.

In terms of emerging-market consumers, per-capita incomes are picking up at a faster pace than in developed countries, says Mobius, which means consumer products, banking and so on in these markets offer attractive potential. As markets have had a strong run-up in 2009, he adds, it should not surprise investors to see corrections along the way.

As for potential investments to avoid, Mobius notes that the pharmaceuticals and utilities sectors have done relatively badly in the past year in relation to the overall market. "Of course, this doesn't mean [these sectors] won't do well in future," he says, but notes that utilities, for example, "present a problem, unless you're in a major emerging-market high-growth country. Governments globally normally keep tight control of how much utilities can charge customers -- they don't like to see electricity bills go up."

There are some exceptions to this, says Mobius. For example, the Brazilian government wanted to build more power stations, so several years ago it allowed utilities to set higher tariffs on energy produced from newly constructed power plants, so as to improve returns on capital and encourage more investment.

By contrast, South African power company Eskom is having problems financing new equipment, due to funding shortfalls.