Should investors still favour emerging economies?

No

Ineke Valke

Senior investment strategist at Theodoor Gilissen, KBL EPB

Ineke Valke, Theodoor Gilissen

While growth rates in many emerging markets remain well above those in developed markets, in general we believe emerging market equities are unattractive. The competitive positions of these countries are being impacted by a range of developments, while lower levels of liquidity on their markets have made them vulnerable to outflows provoked by Fed tapering. Furthermore, historically strong growth was supported by a high level of credit expansion. Those days are over.

Given Chinese growth rates over the last 20 years, for example, a slowdown there was inevitable. Also, the fact that some countries are now evolving from industry-led to consumer-led models can be linked to greater vulnerability and reduced government stimulus. 

The so-called ‘Fragile Five’ (Brazil, India, Indonesia, South Africa and Turkey) are especially at risk due to current account deficits, low currency reserves and dependence on external debt. Some of these countries have lived beyond their means or were simply managed poorly; it’s no surprise they now suffer from structural imbalances. Last year, their currencies declined 20 per cent on average against the dollar, leading to increasing inflation.

An additional challenge is the rise in food prices due to adverse weather conditions. As a consequence and to avoid social unrest, a range of emerging market governments have increased the minimum wage and/or enhanced the social safety net. Such moves may be well intentioned – but wages in many of these countries were already trending upward. In China, for example, wages rose 18 per cent annually over the last decade.

The decline of the Japanese yen and the American energy production revolution have also worsened the competitive positions of many developing nations, especially those that depend on energy exports. In the longer term, we will reach an inflection point when exports start rising again thanks to lower exchange rates – but we’re not there yet.

Political issues also remain key factors for financial markets, as can be seen by the turmoil in Thailand, Turkey and Ukraine.

By comparison, thanks to their strong manufacturing bases, markets such as Mexico, South Korea and Taiwan enjoy a rosier outlook. The liberalisation of the Chinese capital markets could also prove a positive trigger.

We don’t expect the disruption to be as severe as during the 1997-98 Asian crisis, as the currency regimes of emerging countries are far more flexible and depegged from the dollar. The level of currency reserves in many countries is also much higher than in the past, and the banking system has already been reformed.

So why not still buy emerging market equities on the dips? Current emerging market equity valuations, with price-to-earnings of 10, do seem to be more appealing than in developed markets (above 14). But cheap valuations don’t entirely compensate for deteriorating profit growth. Also, these seemingly low P/E ratios are somewhat deceptive, considering the high level of dependence on banking and the low valuations of this sector.

Looking at price-to-book ratios, emerging markets are certainly not cheap measured against developed ones, especially by historical standards. This is why we prefer equities in safe-haven markets like the US and Europe, where growth rates are accelerating.

We see greater opportunities in emerging market bonds. Yields are more attractive, and some of the arguments we have made against equities can actually favour bonds. The slowdown in GDP and profit growth could lead to declining spreads. Inflation is being addressed by rising short-term rates, also leaving room for bond yields to decline. The debt positions of governments overall are in good shape. Also, the fact that the asset class of emerging market debt is dominated by institutions could prove positive as their investment horizon is longer-term. So there is a silver lining in emerging markets – but it is not in equities, at least for now.   

Yes

Jeff Shen

Managing director and head of emerging markets, BlackRock

Jeff Shen, BlackRock

Investors with a medium to long-term investment horizon should continue to consider an allocation to emerging markets. We should remember that current levels of volatility in emerging market equities are not unusual. In fact, nine out of the last 10 years had drawdowns greater than 16 per cent.

It is also important to realise the correction currently underway in emerging markets is not a problem, rather it is part of the solution. Think about it as bitter medicine. The reason for this misinterpretation is incorrect extrapolation from the recent past. In the 1980s and 1990s, interest rates in developing countries had a negative correlation with the business cycle. Recently, however, the fast-paced development of local-currency debt markets gave countries more tools to set macroeconomic policy precisely in times like these. Investors should see the current policy responses as necessary actions aimed to adapt to an environment of reduced macro liquidity (tapering) and to ensure the growth prospects of these countries remain viable.

When markets are being driven by tactical considerations it pays to take a strategic and unconstrained view in a world where continuing country divergence will be the new norm. Investors will benefit from strategies that focus on emerging markets’ growth in an unconstrained fashion, either looking for direct
exposure in companies such as Tencent and Petrobras as well as indirect (e.g Coach, Tiffany) to capture the secular growth from the region. The alternative to not investing in emerging markets would be to risk missing out on an asset class that is poised to contribute more than half the world’s output in the next couple of years.

Reforms in emerging markets will vary by country. The speed at which they are implemented will depend on governments’ appetite to undertake sometimes deeply unpopular changes. For example, with a new, popular and politically savvy president in his second year in office, Mexico was able to get Congress approval for far-reaching telecom, fiscal and energy reforms. Other countries, for example those facing elections this year, will find it more difficult to summon the political capital to push these reforms.

Political turmoil represents, in most cases, an opportunity for investors because markets tend to overestimate its effect on the long-term prospects of equity and debt assets. It is important to remember that the positive experience enjoyed by investors in emerging market a few years ago is in part due to the structural changes put in place after the 1990s crisis period, as well as the tailwinds provided by easy access to cheap financing and high commodities prices. But these tailwinds also slowed the speed of reform by creating a false impression that all was good. The quality of economic policy tends to improve with market pressure and the different speeds of adjustment results in countries where policy response is more advanced, such as in India, than in others, for example Turkey.  

Headline stories coming from Venezuela and Argentina are increasingly being analysed in the context of self-inflicted problems as a result of unsustainable rigidities in financial asset prices with little real or financial ways to affect other countries. Political turmoil will facilitate the transition to the new norm of country differentiation. This will mark a welcome departure from previous turbulent episodes.