Investing in emerging markets

Q Whatever people say about the strength of emerging markets, about their important position in the world, particularly the Brics nations (Brazil, Russia, India, China and South Africa), their equities have underperformed developed markets for the last three years. Do you expect this to change in 2015?

A Yes, I do. I believe emerging markets could outperform despite a few headwinds, including the expected rate hike. It is more a big confluence of factors than a real catalyst that could trigger the rally. Emerging markets today are relatively cheap compared to their developed peers and earnings growth is starting to pick up again.

In the recent past, during the last underperformance, GDP growth was slowing down, commodities were sliding – like it is the case today and over the last three years – and earnings growth was heading south in most markets, particularly in some emerging economies. If earnings rise, economic growth improves globally, inflation is not a big issue and liquidity remains quite plentiful, there are good reasons to believe they will do better than developed markets.

Q We have had abundant liquidity for the past six years which has fuelled the growth of the developing economies, where a lot of money has flowed from the developed world. Do you feel this trend could possibly come to an end with the imminent termination of quantitative easing by the US Fed?

A That abundance of liquidity – and I believe plenty of liquidity will remain in the world moving forward – was invested in emerging markets, but mostly in the bond markets, and the demand for emerging market bonds and high-yielders in developed markets has been a big factor in driving down yields globally. Very little of that liquidity has been invested in emerging market stocks. But many emerging market equities are high-beta to the world growth, and some are very sensitive to commodity prices and the strength of the US dollar. These factors have determined their underperformance versus developed stocks in the past three years. The biggest exporters of commodities, in LatAm, have suffered the most.

Q When we look at those exporters affected by the fall of commodity prices and oil in particular, do you expect the likes of Brazil and Russia, which is also subject to quite stringent sanctions, to continue to suffer?

A Probably yes in the short term, certainly for Brazil, which compared to other economies in the emerging markets universe is a little bit more expensive. As the country is a net commodity exporter, and commodities, such as oil and food, are a big weight in its index, the fall of prices will impact the domestic equity market very strongly.

Also, with no reforms, a sluggish, decelerating growth, quite high inflation, sticky current account deficit, you do not want to invest in Brazil today. But longer term there is a strong potential there because it’s a country full of resources, and demographics are very positive. If the new government has a better reform agenda, and is more market-oriented, which we believe will be the case, then Brazil might become quite a compelling investment case in emerging markets. You would underweight Russia because it has a trade deficit.

Q Everybody today is talking about China and its growth figures. The government has a marginal argument with other authorities in the country about how high above 7 per cent the growth rate is, but other people outside China are saying those figures are too high. Recently one of the investment banks said the growth figure is actually 2 per cent less. Are you worried about these measures of Chinese growth, which could be much less than we are actually being told?

A In many of the emerging markets you would have these doubts, not just China. I tend to believe in official figures.

What is really striking is that, even growing at 7-6 or even 5 per cent, today China would contribute more to world growth than it did 10 years ago with 10 per cent growth. Some official institutions estimate the Chinese potential growth is about 7 per cent now, which is fully sufficient for China to relocate its resources properly and not increase unemployment rate for example, which is one of the most important social factors for the country.

I am quite positive on China. The market believes the reforms are behind schedule but we trust they are on schedule, if not a little bit ahead in some areas, and they will be more market-oriented. The deregulation process is sound and the recent decision to establish an anti-corruption task provides support for the longer-term sustainability of the economy.

Also, it is worth mentioning the SOE (State Owned Enterprises) reform, which is likely to increase productivity going forward. Today margins are quite compressed due to these SOEs. But if they allow private investments in these firms more than in the past, then probably we’ll see higher productivity, better profit margins, with earnings going up and the market reacting positively.

Q What are your biggest fears about China? Is it problems to do with the property and construction industry, with the construction activity affecting so many other parts of the economy? Or is it the shadow banking scare stories we’ve heard about so much?

A It is probably related, because there are definitely links between construction real estate activity and shadow banking. So yes, probably the biggest scare is that shadow banking goes out of control. At the time being it seems to be under control, but it can derail at some stage and could probably trigger the hard landing in China people have been talking about for quite a long time now.

My central case scenario is that the Chinese authorities are watching very closely the situation, because they are very conscious of that risk, and will intervene if they see it is going in a negative direction, as they did in recent past. They have a lot of leeway to counter any phenomenon that would endanger financial stability in the domestic economy. And around 40 per cent of savings rate plus $4tn (Ä3.2tn) plus of currency reserves are quite a buffer, particularly in a regulated economy such as China.

Q How much influence does the Chinese economy have on other developing markets, and how much of the indices are actually made up of Chinese stocks?

A China’s weight in the MSCI World Index is quite big, around 20 per cent now. Being the second biggest economy in the world in purchasing power parity terms, if China is not doing well it has an impact on world growth, not just emerging markets growth. Many emerging economies are very geared to world growth, because they are exporting countries, manufacturers, or commodity producers. 

Also, most of the time markets are kind of behavioural animals. If people start to think China is not that bad, there is less risk of hard landing and earnings growth is going to be positive, that might be one of the triggers for emerging markets to move up again. And today, the consensus forecast about the outlook on China for 2015 is more positive than it has been for 2014, which was not negative.

Q Which emerging markets would you recommend people should look at in 2015? And what are the key characteristics that unite those markets?

A You have to base your views on assumptions. If you believe that the dollar, and there are good reasons to believe it, will continue to strengthen, compared to what it is today on trade-weighted terms; if you believe that commodities will remain lowly priced –although they are still quite expensive compared to 15 years ago but less priced than a few years ago – and that you may even see the prices move down a little bit further on crude oil, in particular, like people seem to expect – then you already have two assumptions which tell you to avoid the producers of commodities and buy commodity users.

Most of the countries to avoid are found in Latin America, such as Brazil. You would underweight Mexico, which has a trade deficit, or Chile. Also you have to take into account the dollar strength, which makes the funding a little bit more expensive for countries that have external debts.

Asian markets are showing positive characteristics. You may overweight them but not all of them, of course. Malaysia is a net exporter of commodities for example, but is one of the exceptions and quite a small market. China, Korea, the Philippines and other Asian markets are really the winners from lower commodity prices, as that is going to raise profit margins. Also, most of these countries, if not all, have positive current account deficits, do not need external financing and are quite sound in terms of fiscal deficits. If you go with fundamentals, you would go with these countries rather than LatAm or Emea markets.