Emerging markets: Tumbling, or just stumbling?
Emerging markets comprise a scatterplot of disparate economies, drawn from every quarter of the globe, and exhibiting an extremely diverse range of shapes, sizes, political regimes, trade composition and financial circumstances. Included in the mix are some of the largest economies in the world, such as China, and also India and Brazil, which match France and Italy, respectively, for size.1 Also represented are some of the smallest economies such as Chile, Hungary and the Czech Republic which, while still larger than, say, New Zealand, are only around 1% the size of the United States.2
The global emerging market equity indices and the global emerging market debt indices both contain around 20 countries—although with a degree of membership mismatch—and the currency market opportunity set is broader yet again. With such a large and colorful population of often tiny markets, it’s little wonder that the emerging market universe is a reliable ongoing kaleidoscope of success stories, investor grief and eyebrow-raising headlines.
Before exploring the present discomfiture of emerging markets, it’s worth recapping the stylized investment case which supports them. Key planks in that case include:
- Historically high growth rates, befitting the developing flavor. Emerging world real gross domestic product (GDP) growth is running at 4.5% in 2018.3
- Young, dynamic demographics which contrast favorably with the developed world. Annual growth in the working-age population is 1% to 2% in Central America, Africa, India and Southeast Asia, compared with -1% in the developed West.4
- Historically attractive valuations. On the basis of price-to-earnings and price-to-book ratios, emerging market equities are currently trading at a discount of 15% to 20% in comparison to the developed world.5 In a similar vein, emerging market debt indices are currently trading at a 4% yield premium to their developed counterparts.6
So, what’s going wrong right now?
In the first place, not all emerging markets tick all of the boxes as described above. Brazilian real GDP growth, for instance, has been struggling to get into positive territory in recent years. Meanwhile, in China, demographics are poor, and we believe the country’s labor force is likely to start shrinking in the years ahead, following three decades of the one-child policy. We also believe that the Indian stock market is trading on elevated valuation metrics.
Secondly, we contend that there are a number of false notes in the dynamic growth at a reasonable price characterization of emerging market economies. For starters, we feel that many have questionable governance arrangements, with few checks and balances to ensure sensible policy-making. In addition, a number are more or less heavily indebted, sometimes with that debt denominated in hard foreign currencies.
Of those in debt, several are running trade deficits and are thus reliant on investor confidence to sustain funding. Countries generally regarded as more vulnerable include Turkey, Argentina, Hungary, Indonesia, India, Brazil and the Philippines. Furthermore, some emerging economies are narrowly dependent on just one or two export industries and are therefore hostage to swings in global commodity markets. Productivity and profitability can also be an issue, with returns on assets struggling to reach reasonable levels in many emerging economies, and with returns on equities typically only propped up by financial leverage. All told, there are as many individual circumstances surrounding these economies—and as many investment cases to be made or quashed—as there are emerging markets themselves.
The Turkish currency crisis: The canary in the coal mine?
An immediate investor response to the recent problems in emerging markets such as Turkey, Argentina, South Africa and Indonesia has been to view each nation’s difficulties as idiosyncratic—small in the scheme of things, and of their own making. True as this may be, we believe it’s worth checking counterparty risk. Zeroing in on the Turkish currency crisis, for example, we note that Spanish and French banks will be particularly affected by any losses on Turkish loans, but with exposures typically no more than 1% or 2% of bank capital for most creditor nations7, we believe this is a manageable situation at this stage. Indeed, insofar as policymakers at the major central banks respond by easing back on policy tightening, the current emerging market setbacks may well elicit more stimulatory policies than might otherwise have prevailed.
Despite the apparently small size of current woes, however, we believe that investors—and not just emerging market investors—should be alert to the possibility that the emerging market crises of 2018 may be symptomatic of darker, and more systemic global issues. This is the Turkey is the canary in the coal mine interpretation—and it’s not hard to form a join-the-dots narrative about the last nine months. The seminal event, in such a narrative, would be when, in October 2017, the U.S. Federal Reserve (the Fed) announced that it would be pivoting from quantitative easing to quantitative tightening after 10 years of sustained monetary support. Then, in succession, we saw Wall Street dive in early February of this year, with currency woes hitting Argentina later that month. The Fed then hiked rates for the sixth time in three years in March, the Russian rouble depreciated in April, gold prices sagged in May, the South African rand tumbled in June, the Fed hiked again the same month, and Turkey moved into full-blown crisis mode in August. Meanwhile, the U.S. dollar has been persistently resilient over the same period.
Maybe so, but we believe that the situation is potentially of significance for developed, as well as emerging market, assets and will need careful monitoring going forward.
Absent such a fin de siecle interpretation, however, at least over the next six to twelve months, we believe selective investment in better-quality emerging markets may be well worth investigating at this juncture. Not only are high growth and supportive demographics still to be found in many emerging markets, but we believe that value—already good in many cases—has been further strengthened. We see this as the case not only in security markets but in the corresponding currencies as well, due to indiscriminate investor selling of anything with the emerging market label.
After all, buying quality assets that are being temporarily shunned by investors for reasons that are tangential and/or ephemeral is what investment opportunism is all about, right?
1 Source: https://www.weforum.org/agenda/2018/04/the-worlds-biggest-economies-in-2018/ 2 Source: https://www.imf.org/external/datamapper/NGDPD@WEO/OEMDC/ADVEC/WEO/JPN/FRA
4 Source: United Nations Population Division.
5 Source: Thomson Reuters Datastream. As of Aug. 15, 2018.
6 Source: Thomson Reuters Datastream. As of Aug. 15, 2018.
7 Source: Bank of International Settlements (BIS). Spain is unusual, and exposures on this measure are significantly higher.