With the global financial system expected to remain under stress for much of 2009 there is little consensus over whether non-Asian emerging market investors should either adopt a defensive asset allocation stance to preserve capital or realign their asset mix to benefit from the growth of equities in anticipation of a market recovery.

In reality, it is a tough call that is fraught with as much uncertainty as the outlook for non-Asian emerging markets. Erik Nilsson, senior economist with Bank of Nova Scotia’s international research group in Toronto says it all depends on whether “you’re an optimist or a pessimist” or whether you see the “poisoned chalice as half full or half empty.”

Arguably, those investors who see the poisoned chalice as half empty are not confident that the market would recover and would most likely have a bias to a defensive asset mix. Conversely, investors who believe the chalice is half full will most likely increase their exposure to equities with the expectation that the markets would recover.

Extreme uncertainty stems from a number of interrelated factors at the global level which will have a direct impact on the performance of emerging markets. At a macro level, the world economy is expected to contract for the first time in 50 years, although non-Asian emerging markets are forecast to continue to grow, albeit at an average of about just over half of last year’s pace.

The slowdown is compounded by the fallout from the global credit crisis which has turned out to be far more severe than originally believed, with expectations of more bad news to come. “A lot of nasty surprises lie ahead,” says Mark Grammer, vice president, investments with Mackenzie Financial Corp of Toronto and lead manager of the Mackenzie Universal Global Future Fund. He expects all the “bad news to come to an end by mid- year.”

This sentiment is echoed by the 2009 outlook of various banks and investment houses. UK-based Barclays Bank PLC for instance, states the first quarter “is set to be considerably worse than anything in the current cycle thus far” in its 2009 outlook issued in December.

Incidentally, leading institutions such as the International Monetary Fund (IMF) and the International Institute of Finance (IIF) have made downward revisions to their earlier 2009 forecasts in the fourth quarter, indicating that the slowdown is greater than previously anticipated – causing alarm bells to ring even louder.

While massive fiscal stimulus, the injection of substantial liquidity and capital into the financial system, asset purchases and debt guarantees by governments have eased the pain and stimulated some confidence in the markets, the dust has not yet settled and non-Asian emerging market investors will likely remain on the sidelines in 2009.

“When the world is off kilter, investors revert to risk aversion and stay with safe assets,” says Charles Bastyr, portfolio manager with Toronto-based Meadow-bank Asset Management. As a result, “non-Asian emerging markets will be orphaned until confidence returns to the developed markets,” he adds.

Up until about mid last year, non-Asian emerging markets were riding high in spite of the credit crunch that was wreaking havoc in the developed world. However since then they have been caught in the downdraft and have sold off more than their developed counter-parts on the back of substantial deleveraging by institutional investors – especially hedge funds, says Grammer.

In addition, according to the IIF inter-bank flows – that is, funds from banks in mature economies to emerging economies; and portfolio equity and debt flows to emerging markets have also fallen sharply, reflecting a more pronounced adjustment of investors’ earnings expectations.

As well, non-Asian emerging market currencies have depreciated significantly against the US$ since mid 2008, losing about a third of their value. It is anticipated that the US$ will weaken by mid 2009, easing repayment pressures in US$-denominated debt held by these countries as well as corporations. “On balance, we think the period of strength in the US$ will be relatively short-lived,” says Nilsson. He believes that other major currencies should appreciate against the US$ in the second half while Mobius contends that currency movements will be volatile in 2009 and that the currencies of countries with high money supply growth – that is government induced liquidity - should weaken.

Heading into 2009, the drying up of inter-bank flows and foreign currency funding pressures have caused emerging market corporate spreads to reach near distressed levels, increasing default risk largely due to refinancing constraints. In December, Ecuador defaulted on its debt, and it is anticipated that other countries in the region could follow suit. Notwithstanding, the IIF said in December that “anecdotal evidence seems to suggest that foreign currency funding pressure in emerging markets has eased somewhat from the stress level in October, even if tension persists and funding costs remain elevated.”

The global downturn has resulted in lower demand for oil, copper, iron ore and soft commodities whose prices have fallen steeply. Latin American and African countries which are net exporters of these commodities have been hurt by the price declines, while the Middle East has been hurt mainly by oil. On the other hand, Nilsson says Eastern Europe is a beneficiary of lower commodity prices since the region is not an exporter of commodities.

Chuk Wong vice president and portfolio manager with Goodman & Co. Investment Counsel Ltd. in Toronto says that recession in developed countries appears to be deeper than expected and it will be a while before confidence returns to non-Asian emerging markets. Consequently he does not anticipate making any major portfolio shifts in 2009. Nonetheless, he suggests that if commodity prices turn around, it will be hard to resist increasing exposure to Brazil and Russia, although he admits, “this will be a bit tricky.” Wong currently has limited exposure to the commodity sector in both Brazil and Russia.

Mark Mobius, Singapore-based portfolio manager of the Templeton Emerging Markets Fund currently has an emphasis on consumer and commodity stocks with strong exposure to Brazil, Turkey and South Africa. He will not wait for economic recovery but is positioning his portfolio now for the recovery. “It is not a good idea to try to time markets since the accuracy of such timing is next to impossible,” he says. Mobius however cautions that “anyone going into equities must do so with money which they don't expect to need for five years.”

In the Middle East and North Africa, Daniel Smaller, partner at Dubai-based Algebra Capital, which is sub-advisor for the Franklin Middle East and North Africa Fund believes that although oil prices have come down, he will be focusing on opportunities in roads, power, bridges, desalination plants, the fertilizer industry, consumer durables, and counter cyclical plays. He says many companies in the region have distinct catalysts and high earnings and are trading at cheap price to book and price to cash flow valuations. Smaller believes that “there is no right time to invest in equities” and will consequently maintain his focus in sectors identified.

Grammer likes Brazil and Mexico where he has exposure to oil and beer. He does not plan to make any portfolio adjustments in 2009. He plans to focus on what he calls “cockroach companies” – defined as companies “whose businesses are relatively easy to understand, have almost no debt on their balance sheets, and no matter how bad things get can survive for two to three years with a 20% - 30% downturn in revenues.”

Eastern Europe is the least favored region which Wong describes as the “next Asian crisis waiting to happen.” He says that a contracting developed Europe upon which the region is dependent for exports and substantial “mismatch of foreign currency debt” will hurt the region.

“There are too many signs of uncertainty; investors would have to look for signs of recovery and until they appear should hoard cash,” suggests Bastyr.

Conversely, Mobius says that non-Asian emerging equities “should be at the top of the list since equities will give great protection from the high expected inflation, which will come from higher commodity prices.” He adds, these “emerging markets are expected to perform the best in view of their higher economic growth characteristics” but cautions that investors must be in for the long haul.

Nillson anticipates that the market will bottom out by mid-year, followed by a “mild upturn in the second half”, a view with which Mobius generally concurs.

Barring the structural uncertainties of investing in non-Asian emerging markets, Mobius says “the major risk is faulty analysis where we are unable to determine the profitability and growth charac-teristics of the companies in which we invest. For that reason we are continually improving our research and working hard to ensure we understand the manage-ment of the companies in which we in-vest.”

Dwarka Lakhan is the Editor of CRA Magazine. He is the President & CEO of the Caprion Group of Companies which provides integrated consulting services to the financial services industry. Phone 905-850-7715 Email dlakhan@caprion.ca Web www.caprion.ca