Upbeat investors continue to back developing regions

Headwinds such as China’s slowing growth, along with the prospect of a US interest rate hike and a stronger dollar, are expected to hamper emerging markets (EM) and impact capital flows into EM stockmarkets in the short term. 

However, investor interest has been piqued by the deep value on offer compared with developed markets. EM equities trade at a discount of more than 30 per cent, at a time when value assets are difficult to find. 

Although growth in emerging markets is now lower, these economies are beginning to shrug off their close correlation with the commodities cycle. On a corporate level, many emerging market companies have also responded well to tough times, cutting costs and implementing strategies that will eventually boost profitability. 

Some investors are concerned weaker commodity and oil prices have put further pressure on energy-related companies, but while the oil price slump has strained the budgets of producers such as Russia, overall it could provide a fillip because almost 75 per cent of emerging economies are net oil importers. Potential benefits include improved fiscal positions via reduced oil subsidies, narrowing current account deficits as oil import bills tumble and falling inflation leading to lower interest rates.

“Given the discount compared with their developed market peers, and the anticipated improvement in corporate profitability, we are confident in the EM outlook,” says Osamu Yamagata, investment manager at Aberdeen Asset Management. 

The normalisation of Fed policy is based on the assumption of a sustainable US economic recovery which bodes well for emerging market exporters and may help offset the effects of a China slowdown, he explains. “A strong US dollar is not necessarily bad for emerging markets either. A key distinction to make is that current weakness in emerging market currencies is relative to the dollar’s strength, and not because of fundamental problems in the developing world.”

Worries about US monetary tightening has stoked fears that emerging economies’ current account deficits, hitherto financed by the large global supply of dollars, would no longer be sustainable, says Mr Yamagata. However, by raising interest rates, emerging economies have reined in these deficits. For example, India’s central bank predicts the country’s deficit will shrink to 1.3 per cent of gross domestic product this fiscal year, down from a record high of 4.8 per cent in 2012-13. “This reduction in deficits leaves emerging markets much less vulnerable to further signs of US monetary tightening,” he adds.

 However, China’s growth is a persistent concern, the bear case being a severe hard landing after years of credit fuelled expansion, and the bull case that reform and the corruption crackdown will sow seeds for a more durable economy and another period of growth. China’s economy grew by 7.4 per cent in 2014, its weakest for almost a quarter of a century, and early in March, Premier Li Keqiang announced a lowered growth target of approximately 7 per cent for this year, and cut the trade growth target for 2015 to around 6 per cent.

More positively, the nation’s monthly trade surplus hit a record $60.6bn (€56bn) in February, as exports grew by 48.3 per cent year on year to $169.2bn, and imports dropped by a fifth to $108.6bn, according to the General Administration of Customs, although export comparisons were flattered by the timing of the Chinese New Year.

Wei Li, investment strategist at BlackRock’s iShares, takes the view that despite the slowing trend, emerging market economies still have significant growth potential versus developed markets especially over the long term. “It is worth noting GDP in EM has not been conclusively linked to equity market performance,” he says.

Either way, the long EM boom, from 2002 to 2012, undoubtedly caused structural vulnerabilities. “Wages and currencies generally rose in emerging markets over this decade, resulting in a loss of competitiveness versus the developed world,” says Geoffrey Wong, head of global emerging market and Asia-Pacific equities at UBS Global Asset Management. 

Unit labour cost (ULC), particularly when measured in US dollars, has soared in countries such as China, Brazil, Chile, Thailand, Indonesia and South Africa over the last decade, he explains. By contrast, ULC has hardly changed in the US over that period. The currency declines during the ‘taper tantrums’ have partly corrected this situation in some countries but the correction has further to go in major countries such as China and Brazil, adds Mr Wong. 

“At the same time, globally low interest rates during the post-2008 QE period resulted in zero real interest rates, which coupled with massive fiscal stimulus, particularly in China, have resulted in build-up of debt. High debt at a time of slowing growth and a limited ability to export out of the problem, is a poor combination,” he says.

 The traditional rationale for investing in emerging markets, such as demographics, catch-up potential, and urbanisation, seems most intact in India, Indonesia, other parts of southeast Asia, and to some extent Brazil. Some countries are starting to use the growth downturn to implement reforms, but their implementation may be a long and fraught process. India and Indonesia have already cut costly fuel subsidies, while Mexico has made sweeping changes across the education, financial, telecom and energy sectors. China has enacted a raft of financial reforms and other countries will likely feel pressured to pursue a similar agenda.

Many fund managers were particularly enthusiastic about India and Indonesia in 2013-14 when their economies were slow and election uncertainty caused investors to flee. In both cases, reform-minded democratic governments look set to drive expansion, but  stocks are now less attractive having doubled already in many cases. 

“India is probably most advanced in the cycle, having entered the downturn earlier, owing to the political log jam of the latter part of the Congress Party administration,” says Mr Wong. “India does not have the loss of competitiveness issue to the same extent as other emerging market countries.”

While there are not yet signs of a turn in the economy, the earlier collapse of capital spending suggests a rebound is closer in India than other countries, believes Mr Wong, adding the Philippines are also in sound condition, but in contrast to India, it is early in the cycle. “Debt levels started from a very low base, and hence further credit growth is feasible. Similarly, while ULC has risen at a moderate rate over the last decade, it started from a low base. Mexico is another exception to the story, in that it has gained competitiveness over the last decade, especially against other EM countries such as China, allowing it to gain market share in manufacturing.”

However, Will Ballard, who runs the EM income and EM smaller cap funds at Aviva Investors, points out that despite improved earnings forecasts for Indian companies, actual earnings in the last quarter were the worst for the last six quarters and the market could be getting ahead of itself.

Korea is also seen as an interesting market. “It’s cheap top down and bottom up and is very exposed to the global economic cycle which is devilishly hard to predict right now,” says Hugh Maxwell-Davis, portfolio manager, Regional Asia Equity, Eastspring Investments. “The ‘Korea discount’ for governance risk is as wide as it’s ever been, yet we are seeing some signs of more investor friendly policy and a lot of generational change is happening at some of the key Chaebol [business conglomerate].”

If you look at Asian equities today they are trading around one standard deviation cheaper relative to history, adds Mr Maxwell-Davis. “But not only is the headline metric cheap, if you look within Asia the discrepancy between cheap and expensive stocks is the largest we have seen for years. Whether you want to cut by cyclicals, which are cheap, and defensives, which are expensive, or look at it at stock level, there are many opportunities for stockpickers.”

Fund managers are therefore looking at out-of-favour stocks such as non-resource companies in resource exporting countries, as well as the ever-popular Westernisation theme, for example the banking sector in Pakistan where only one in 10 of the population have a current account. 

Mr Ballard points out while large caps are trading on PEs of 12x, mid-sized stocks are more expensive at 14.5x and smaller caps are cheaper, at 13x. This is because investors have shifted to mid-caps where they are confident of some liquidity, but perhaps lack the analysis to go further down the market cap scale. While earnings expectations have come down considerably, with 10 per cent the consensus this year for large caps, estimates for small caps are more than double that. 

Some mega stocks currently trade very cheaply owing to the governance issue, Mr Ballard says, particularly sovereign owned enterprises which are not managed in a way properly aligned with stockholders’ interests. 

In the mid cap space, Mr Ballard likes companies tapped into domestic structural growth such as healthcare operators and education provision, from nurseries to postgraduate courses. “People are not worrying about US rates if they are stuck in India – they will be concerned about their health and education and how to find high quality provision and whether they can afford it,” he says. 

UBS has been positive on the insurance sector in China, driven by demographics and low penetration, says Mr Wong. The e-commerce and internet space in EM is continuing to grow, he explains, adding that in some respects, in countries with poor transportation infrastructure and low car penetration, the case for e-commerce is stronger. 

“Healthcare spending is too low in EM and should rise faster than GDP,” he says. “Within EM there are companies which are world leaders in their field and are able to export to both the developed and emerging world. These can be found in IT services and IT hardware, for example. Their exposure into technology trends gives them a growth driver almost independent of EM growth.”

Aberdeen’s Mr Yamagata points out that “domestic institutional and retail investors are not consistent players in the market, so those who drive emerging markets are typically foreigners. This is important, because foreigners sometimes get concerned about different things from what’s occurring on the ground.” 

He gives the example of quantitative easing, and the impact that the ECB and Bank of Japan can have on liquidity flows into emerging markets, and the disproportionate impact on the performance of these markets.

 “If investors ignore short-term negative sentiment that has nothing to do with emerging market companies themselves, they will be rewarded by improving fundamentals,” says  Mr Yamagata.  

Value for those who can afford to buy and hold

James Butterfill, an investment strategist with Coutts, says the wealth manager is holding China in its discretionary portfolios, but on the advisory side it will first ask the client for clarification of their time horizon. 

“If they can afford to take a longer view then emerging markets do look cheap, particularly Russia. Valuations do typically reverse.”

An analysis of historical data after geopolitical crises such as Yom Kippur, the Iran/Iraq crisis, the invasion of Afghanistan and various Cold War events, reveals that in the three years after the beginning of these crises, there is an average price return of 38 per cent in 85 per cent of instances, adds Mr Butterfill.

Russia is trading on a PE of 3.8x and a book price of 0.47x, while emerging markets as a whole are trading on an average PE of 11x and a book price of 1.4x.

China is also relatively cheap, he says, on a PE of 9.6x. “In the short term, it has banking issues but we have an overweight position and are watching issues such as rising household debt closely. Our belief is that the government will manage to get that down gently and slowly. We know non-performing loans have to rise in the short term, but longer-term it is attractively valued.”

Coutts tends to look for active managers and says there is no shortage of excellent candidates, although track records in this space are limited. Active management is seen as critical at a time when the US is threatening to raise rates in six to nine months. “These are multi-speed economies, and when rates rise some markets with large debts denominated in dollars will suffer.”

VIEW FROM MORNINGSTAR: Defensive strategies well rewarded

Emerging market equities have bounced back after dropping more than 10 per cent (in euro terms) in 2013. Over the 12-month period ending March 1, 2015, the MSCI EM NR index delivered 29.3 per cent returns while the S&P 500 TR and the MSCI World NR posted even more impressive gains of 42.2 per cent and 32.8 per cent respectively. 

One of the key factors behind these strong returns is monetary policy. Western economies and Japan have embarked on aggressive quantitative easing programmes which provide abundant liquidity, helping to fuel risky asset prices around the world. 

Funds in the Global Emerging Markets Equity peer group returned 27.2 per cent on average from March 1, 2014 to February 28, 2015, with a wide dispersion between the highest-performing funds, which posted gains in the region of 40 per cent, and the lowest ranked, which barely made any money. More defensive strategies have tended to do better than others in an overall up market with quick shift in risk appetite. 

Having the right country exposure was another way to win last year given the wide dispersion in returns between countries. Commodity-driven economies such as Brazil and Russia were among the poorest performers while Turkey, India or China equity indices have produced double-digit returns.

Silver-rated Vontobel Emerging Markets was among the most successful funds over the last 12 months with a 39.7 per cent gain. The fund ranked in the first quartile over that period. Its overweight in India was clearly beneficial but we think there is much more to this fund. Rajiv Jain has been in charge since 1997 and has a wealth of experience in emerging markets. He focuses on high-quality growth companies that maintain high return on equity and have some pricing power, building a high-conviction portfolio of 50-90 stocks. 

The fund deviates substantially from the benchmark and competitors, with large over and underweights at the country and sector levels. The focus on high-quality companies with steady and defendable earnings growth implies a bias to economies with large domestic demand – such as India – or consumer defensive stocks –tobacco, food and beverages – with competitive advantages. This investment approach has produced excellent long-term results under Mr Jain’s leadership.

Bronze-rated Robeco Emerging Conservative Equity also performed well. The fund is managed with a quantitative model based on risk, valuation and momentum. The focus on low-volatility names clearly paid off last year but we think this is also a good fund to hold for the long term. 

Robeco has a long history of quantitative investment and the team in place here is well resourced and experienced. The management team is led by Michael Strating, who has worked at Robeco since 1990 and has managed various quantitative strategies on European mandates. We are also impressed by the cost structure here since this is one of the cheapest funds in the category, a clear advantage to outperform over a full market cycle. 

Mathieu Caquineau, manager research analyst, Morningstar