Emerging markets down but not out

Why on earth should wealth managers bother with emerging markets? The MSCI Emerging Markets Index has zigzagged alarmingly over the past few years, and is still double digit percentage points down from its 2011 peak.

Investors see more market turbulence to come, as the US Federal Reserve continues to taper quantitative easing, prompting breakages in the ‘Fragile Five’ nations prone to high current account deficits: Indonesia, South Africa, Brazil, Turkey and India. Some of the Fragile Five, as well as other emerging economies, have their own political problems to contend with too.

Private bankers have not, however, abandoned emerging markets. Most have responded by emphasising the long-term nature of their investment strategies and the opportunity to find value in parts of the huge emerging market universe that remain economically and politically stable. Although many acknowledge the investment potential of distressed markets hit by instability, most are reluctant – just yet, at least – to take the plunge by investing in distressed assets in trouble-prone nations.

Among wealth managers, JP Morgan Private Bank lies towards the bearish end of the spectrum. Over the past six months it has liquidated all holdings in emerging market currencies and debt. It has also gone significantly underweight in emerging market equities – the biggest single shift in its portfolio.

“If a country needs foreign investment in order to grow, I don’t want to invest in that market,” says Cesar Perez, chief investment strategist for Europe, the Middle East and Africa at JP Morgan Private Bank in London. “If it’s dependent on commodities, I don’t want to invest in that market either.” In other words, a country has to work very hard indeed to pass muster with JP Morgan.

Many wealth managers regard reliance on foreign capital as dangerous because much of it is likely to be repatriated by investors, as the Fed reduces liquidity by tapering. This could force countries with current account deficits funded by foreign capital to raise interest rates to economically punishing levels, in order to keep capital in the country.

When it comes to economies that are largely commodity-based, such as Brazil, many private bankers are bearish because of the change in China’s business model from commodity-intensive investment to less commodity-hungry consumer growth. They also point to recent high global capital spending on commodity extraction, which has made the supply-demand balance less favourable to commodity producers.

JP Morgan is wary of the classic argument made by investors during periods of turbulence: that it generates opportunities to buy stocks at bargain basement prices. Prices in Fragile Five countries such as Turkey have fallen, but not by enough.

“If we want to invest in distressed assets, we will have to see prices fall further,” says Mr Perez. Looking at average price-to-book ratios, JP Morgan Private Bank calculates emerging market ratios are about 30 to 35 per cent lower than developed markets. If this gap widens to 50 per cent, it is time to start looking at emerging markets as a sector with plentiful opportunities to buy distressed assets, he says.

Despite its concerns, JP Morgan still sees some areas of promise in emerging markets, such as India, which has recently eased potential economic instability by reducing its current account deficit.

Mr Perez still believes in a deep-rooted structural reason for investing in emerging markets: the opportunity for rapid growth in corporate earnings as countries catch up with the wealth and infrastructure of developed markets. Each private banker has their own favourite example which encapsulates this – Mr Perez cites the fact that the average speed of a train in India is only 5km an hour.

Something different

The notion that some emerging markets can still offer something that developed markets cannot – the earnings growth generated by rapid catch-up – holds water at Citi too. “China is one of the few places in the whole world where wage growth is in double digits – creating a very rapid growth in consumption from a low base,” says Steven Wieting, global chief strategist at Citi Private Bank in London. This creates good investment opportunities for producers of consumer staples such as toothpaste, he says.

Citi is 1 percentage point underweight in emerging market bonds, because of the upward effect of tapering on emerging market interest rates, and 1 percentage point overweight emerging market equities. The moderate overweight in equities – much less than the 6 percentage point excess for developed market stocks – arises partly from its view that after recent falls, many stocks look cheap. Mr Wieting cites the trailing price-earnings ratio of MSCI China of 10, far below its long-term average.

Another positive factor cited by Citi and other private banks is the favourable demographics of many countries – with rapid growth in the working-age population boosting output and consumption, and providing a strong tax base that supports government debt. The demographics are often particularly favourable in frontier markets – those markets which have, because of low liquidity, not quite reached the status of fully-fledged emerging markets. For example, Nigeria’s population is predicted by the UN to rise from 175 million now to 440 million by 2050. In addition, the dependency ratio, the proportion of people too young or old to work, is expected over the same period to drop from 0.9 to 0.7.

This sector presents a quandary to private bankers, however. “Frontier markets offer some really great long-term prospects for long-term investors over a 10-year period,” says Mr Wieting. “However, their weightings in emerging market indices are so low that you have to go way off-benchmark to make a significant investment. This is not something we would usually do in the wealth preservation business.”

Citi sees potential opportunities to buy in emerging markets that have fallen heavily. However, “we try to find markets that are trending up rather than merely bouncing back,” says Mr Wieting – citing Mexico as an example. But in common with Mr Perez of JP Morgan, Mr Wieting is reluctant to adopt this tactic just yet for the countries that have experienced the greatest turmoil. Looking at Turkey, for example, “the political situation could improve or worsen: there are domestic political problems, investment outflows and currency weakness. Moreover, rate hikes could slow the economy.” The Turkish central bank has ramped up its benchmark one-week repo rate to 10 percent to stem the exit of cash from the country.

Look elsewhere

Most private bankers and emerging market specialists argue that they do not need to take risks by investing in unstable nations – however good the returns may prove to be – because there are so many other opportunities out there. They say the majority of foreign countries have not been hit by economic and political instability. When it comes to economic security many, in fact, have current account deficits which other countries would envy.

Others have managed to rein in their deficits. Odile Lange-Broussy, analyst for the Lombard Odier Investment Managers’ Emerging Consumer Fund in Geneva, cites the Philippines’ large current account surplus, boosted by remittances from Filipinos abroad.

She also feels that India’s success in reducing its current account deficit provides a strong backdrop for Indian stocks. Her favourite statistic showing the catch-up potential of emerging markets is that 300m Indians have never tried toothpaste. An even higher proportion are likely never to have tried branded biscuits, or, in the case of Indian women, beauty products. To tap into this opportunity, the fund holds positions in Britannia, a biscuit producer, and Marico, a haircare products maker.

On the other hand, because of North Africa’s current political instability the fund does no currently hold any stocks in the region.

Lombard Odier’s separate private banking arm has no holdings in emerging market debt, and is neutral on emerging market equities.

Coutts takes a more relaxed view than most private banks about emerging market turbulence. As a result, it runs contrary to the trend among private banks by holding an overweight position in emerging market bonds.

Its central case is, as Alan Higgins, UK chief investment officer at Coutts in London, puts it, that “emerging markets have come to terms with tapering”. He believes that bond yields in emerging markets could now stabilize, after recent sharp rises in countries with high current account deficits as central banks increased rates to stem capital outflows. Moreover, Coutts believes that despite tapering, interest rates in developed markets will remain low for a long time. Consequently, developed market central banks do not have much left that will throw emerging markets into economic turmoil.

This leaves strong opportunities in emerging market bonds when compared with developed market debt, in Mr Higgins’ view. “When you look at fixed income in developed markets, it’s pretty hard to get yield,” he says. He notes that by contrast, yields on emerging market local currency debt in particular are high. Moreover, exporters which have significant overseas earnings to offset foreign liabilities – whether they are countries or companies – have an implicit hedge against the risk of weakness in local currencies,” he says. “They can in fact benefit from currency depreciation.”

Some go even further in questioning the widely held assumption that national crises are bad for emerging markets. In 2012, Egypt saw rioting in the streets, but its
stockmarket was up 29 per cent – making it the second best performing emerging market, notes Allan Conway, head of emerging market equities at Schroders in London.

In 2013 the government was overthrown, but it was still up 11 per cent. In Thailand in 2010, the central bank was closed amid political turmoil and streetfighting, but the market climbed 37 per cent – the best performance of any emerging market.

Fears expressed by private bankers about the slew of emerging market general elections over the coming year are also made light of by Mr Conway. Many fret about the political turmoil that could result. However, Mr Conway cites research by Morgan Stanley showing emerging stockmarkets actually tend to rise rather than fall in the months before elections.

He suggests this is because market fears of political disaster, such as the arrival of an extreme political regime, often prove unfounded. Mr Conway cites the case of Lula da Silva, who presided over a period of increasing stability and economic growth in Brazil after coming to power in 2003, confounding fears that he would destabilise it through political extremism.

Market fears present a wonderful opportunity for the likes of Mr Conway. “Overall, investors are very bearish on emerging markets,” he finds. “It’s gone to such an extreme of bearishness that I’ve now moved to a bullish position.” He gleefully quotes data from data provider EPFR, which shows that even since the beginning of the year, net outflows from emerging markets amounted to $20bn (€14.4bn) – approaching the $26.7bn total for the whole of last year.

A warning against placing too much emphasis on relative stability or instability of individual countries also comes from  Joanne Irvine, head of emerging markets ex-Asia at Aberdeen Asset Management in London.

Despite market fears about Turkey, for example, Aberdeen AM has holdings in Bim, a Turkish discount retailer, and even in the country’s Garanti Bank. It cites, in both cases, excellent management and strong balance sheets. Ms Irvine thinks an asset manager with a long-term view should invest in good companies wherever it finds them, as long as the country is basically sound.

A step too far

Even emerging market bulls do not charge at everything, however.  Russia proves an interesting case in point. Before the Russo-Ukrainian crisis, many emerging market investors were bullish on Russia. Schroders had, for example, made Russia a member of the “the Fab Four” – a group of countries, also including China, South Korea and Taiwan, whose large current account surpluses made them ripe for investment. Mr Conway now, however, counsels holding off on buying into Russia until the crisis has eased.

Ultimately, even the most fervent advocates of bottom-up emerging market stockpicking draw the line. Ms Lange-Broussy of Lombard Odier says, for example, that well before the crisis she would not have invested in Ukraine because it was not clear that companies operating there could protect their assets in court. Mr Perez of JP Morgan cites Argentina as a no-go area, citing anti-shareholder government policy such as the seizure of the assets of the Argentine arm of Repsol, the Spanish oil company.

This underlines the fact that although private bankers say they are willing to take risks, they do not, ultimately, see emerging markets as an arena for risky bets in troubled countries. “If, because of political instability, I cannot make an assumption about the return I’ll get, I won’t invest in a country”, says Mr Perez.

“Argentina is a perfect example of that. It has the third biggest shale reserves in the world, and amazing agricultural resources, but I wouldn’t invest in it.”