Written By: Georgina Hellyer
Despite a disappointing performance recently by emerging markets, Georgina Hellyer of Threadneedle outlines why investors should still be optimistic about the sector
For much of the noughties, emerging markets were flavour of the month. With the Chinese economic miracle at the forefront, we witnessed a period of strong economic growth, fast-growing domestic consumption and appreciating currencies. And when, in 2008, the global financial crisis struck, investors began to wonder whether the emerging markets story might even prove resilient enough to withstand the economic turmoil which the developed world found itself embroiled in.
Fast forward to 2014 and the reality has proved disappointing. Over the five years to the end of September 2014, the MSCI Emerging Markets Index has delivered a total return of 24% in sterling terms, while US stocks have more than doubled in value. Meanwhile, UK equities have risen by nearly 60%, and even equities in troubled continental Europe have increased by 36%.
Yet many of the features that underpin the attractiveness of emerging market equities remain in place:
- Potential GDP growth remains higher for emerging market economies than for their developed market counterparts.
- They are home to a rapidly-expanding middle class that is eager to enjoy a higher standard of living and consume a wider range of goods and services.
- Government debt levels are low in comparison to countries such as the UK, US and Japan and, in some emerging economies at least, consumer credit penetration is also low.
- The corporate sector is benefiting from a slow but steady improvement in regulation and corporate governance. Indeed, an increasing number of world class companies are to be found in emerging markets.
So what has the problem been? Two main factors must take the blame.
First, the Chinese economic powerhouse is stalling. A slowdown in the growth of the working age population and rising real wages has seen China begin to lose competitiveness versus other global manufacturing bases and this, coupled with the weak export demand from the struggling developed world, has left the country no longer able to rely on net exports to drive growth. For several years, Chinese authorities were able to offset this with a massive programme of infrastructure spending and by allowing loose monetary conditions to fuel a domestic property boom. Now, however, the rapid increase in local government and corporate debt has made this alternative path unsustainable. So now the authorities have switched to a third path: focusing on creating a domestic demand-driven growth model. But the process of transition is a slow one, and moreover, is made all the more complicated by the previous cycle of overinvestment which has supressed corporate profitability and left many companies with weak balance sheets.
A problem for China, yes, but also a problem for other emerging countries whose growth was previously fuelled by China’s voracious appetite for their natural resources, driven by the aforementioned boom in property and infrastructure. Countries such as Brazil and South Africa now find themselves with a deteriorating trade balance, and are thus increasingly reliant on foreign capital inflows to fund their own demand for imports.
At the same time, emerging markets remain vulnerable to the ebb and flow of global liquidity which, in the era of quantitative easing and close to zero interest rates across much of the developed world, have proved all the more dramatic. The Federal Reserve launched its QE programme in 2008 to stimulate the US economy and ward off the threat of another Great Depression. However, QE also drove down the return investors could obtain from assets such as government bonds. Consequently, some sought more profitable opportunities elsewhere, including in emerging markets, resulting in very large inflows to fixed income and equities. However, this has left emerging markets vulnerable to the eventual tightening of monetary policy or, as the “taper tantrum” in the summer of last year proved, to even the discussion of such.
With the Federal Reserve now steadily winding down its QE programme, this development has once more weighed heavily on our asset class and, in particular, on those countries with large current account deficits, reliant on foreign capital flows to finance them. The impact here is felt not only in depreciating currencies as fixed income investors reduce their exposure to a country’s debt, but also in the domestic economy as central banks are forced to increase domestic interest rates in order to defend their currencies, which then weighs on a country’s domestic consumption and investment. Current account deficit countries are therefore forced through a painful readjustment process. And for exporters of commodities who are currently facing deteriorating terms of trade, this adjustment process is even more difficult.
So, does all this mean that the prospect of high returns from emerging market equities has disappeared for good?
For investors with a longer-term time horizon, we believe that the answer is emphatically no.
Firstly, whilst the process of correcting the imbalances built up over previous cycles may be a painful one, experiences such as the Asian crisis have shown that it can most certainly be done.
Perhaps just as importantly, the structural growth drivers that have long made emerging markets an attractive area to invest are as compelling as ever, with areas such as healthcare, e-commerce and modern food retail formats continuing to see impressive growth rates.
And in 2014 there is reason for particular optimism. The last couple of years have seen a number of important elections take place across our asset class, with new governments elected in Mexico, India and Indonesia and the upcoming closely-contested presidential election in Brazil. Whilst this has created significant amount of volatility in those respective markets, the positive development has been the subsequent election of leaders with strong reform mandates.
Most exciting perhaps is India where earlier this year Narendra Modi and the pro-business BJP party swept to victory on a platform that promised to tackle the corruption endemic in the Indian government and corporate sector and push through a much-needed programme of infrastructure spending. The problems of the Indian economy are manifold, including twin budget and current account deficits which need to be reduced. However, already there are signs that progress is being made and recent policy announcements have been encouraging.
Mexico too has an exciting reform programme of its own. President Enrique Peña Nieto, who was elected in the summer of 2012, has been pushing through a series of laws to open up the energy sector to private investors and hopefully unlock some of Mexico’s enormous potential in deepwater oil and shale gas.
Elsewhere, the election of Jokowi Widodo in Indonesia – the first person from outside the military and political elite to ever become president – has also been greeted favourably by investors. Without a working majority in the parliament his ability to enact reforms may prove more limited, but nonetheless his election is surely a step in the right direction.
And finally China where, despite no democratic elections, the authorities are starting to address some of the deep-seated structural issues which the economy is facing, pushing to reign in investment in unprofitable industries, and reduce leverage in the corporate sector. Progress on implementation will be hard to predict, especially as it involves dealing with corruption and vested interests at the same time. Moreover, the process is likely to result in slower economic growth in the near term in exchange for a more sustainable economic growth model in the long-term, which could ultimately prove politically and socially untenable. Nevertheless, here too the direction of change is without doubt positive.
So where to next?
Now, we believe, is not the moment to lose faith in emerging market equities as an asset class, particularly when valuations compared to developed markets remain so attractive. However, now more than ever it pays to differentiate. Whilst emerging markets may be a single asset class, they are anything but homogenous. Excitingly, this provides ample opportunity for the active investor to seek out higher returns. To our minds, the key lies in identifying companies which are best-positioned to benefit from these various reform programmes, plus those which have resilient enough business models and underlying growth drivers to outperform in this still-challenging global macro environment. The good news is that there are an increasing number of world class companies to choose from, with capable management, healthy balance sheets and strong cashflow generation, allowing them to finance their growth projects without the need to take on lots of leverage. Emerging markets remain a world of opportunity.