GLOBAL EMERGING MARKETS OCTOBER 2016

Transcription

1 GLOBAL EMERGING MARKETS OCTOBER 2016 FOR PROFESSIONAL CLIENTS ONLY THE TIDE IS TURNING Emerging market investors have spent the last three years worrying about China, the US Federal Reserve (Fed) and economic growth. Of late, the Brexit vote in the UK has increased concerns over global economic growth, as well as raised questions regarding the potential impact on emerging markets. However, we believe that conditions are changing and for the first time in some years, emerging markets look placed to outperform. Profitability has been recovering, and the emerging markets index has begun to outpace developed markets. In this viewpoint I address the above concerns and explain why this asset class is such a strong investment proposition today. Kim Catechis Head of Global Emerging Markets

2 active VIEWPOINT: GLOBAL EMERGING MARKETS Earnings at a possible inflection point The first-half earnings reporting season in emerging markets is now over and the results point to a positive surprise (+8%) * from the index constituents for the first time in over three years. The biggest positive earnings surprises came from construction materials in Latin America and Thailand, water utilities in Brazil and the energy sector, the last outperforming very low expectations. At the other end of the scale, the industrials sector disappointed the most, underlining the challenges of the prevailing weakness in the capital investment cycle around the world. There was also some disappointment in the telecommunications, healthcare and consumer staples sectors. Consumer staples has been a mainstay of many emerging market portfolios but we have been sceptical for some time about the sustainability of this sector s valuations. Looking out from here, our optimism on earnings growth is based on three factors: stronger economic growth, continued productivity improvements and the anticipation of looser financial conditions. Together, they represent a powerful combination which will serve to draw investor interest to opportunities in the emerging market asset class. And, importantly, for all the negativity there is no shortage of success stories in these markets, including names we like such as Samsung Electronics, Tencent, ICBC, Alibaba and TSMC, which have joined the ranks of the world s largest, fastest growing and most profitable companies. Economic growth seeing the wood for the trees Global growth expectations are clearly lower than a year ago, but the IMF s latest forecasts demonstrate that emerging markets continue to monopolise the highest rates of real GDP growth available (4.6% versus 1.8% for developed markets in 2017). India, for example, is expected to grow at 7.4%, with China projected to clock in at 6.2%. While there is inconclusive evidence for a correlation between GDP growth and stock market returns, it is undeniably an important factor for all the companies that we invest in. And although many countries will be posting economic growth numbers that remain below their long-term averages, this trend needs to be viewed in perspective. We prefer to think of the decade prior to 2008 as an unusually supportive period, so the level of growth that we expect going forward is actually much closer to sustainable long-term averages. Further evidence of a positive outlook is provided by the emerging market manufacturing purchasing managers index (PMI), which in recent months has climbed back above the significant 50 mark for the first time since May In Asia, it is driven by the technology sector cycle (new mobile device product launches) which benefits tech-dependent countries such as Korea and Taiwan and thus is an unreliable signpost for a generalised capex cycle. In Brazil, the manufacturing PMI appears to have bottomed in May, probably due to a cheaper currency boosting exports, but also increased confidence regarding policy direction since the change of government. Looking out from here, our optimism on earnings growth is based on three factors: stronger economic growth, continued productivity improvements and the anticipation of looser financial conditions. Please be aware that the information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the securities discussed here were, or will prove to be, profitable. *Source: Factset, September Source: World Economic Outlook, July Source: Factset, September 2016.

3 PAGE 3 Concerns on China overdone A year after the markets were surprised by the Chinese authorities yuan devaluation, there now seems to be a better understanding of economic dynamics there. Indeed, investors appear to have accepted that China is not going to have a hard landing and after the publication of the latest five-year plan, the markets seem to be pricing in a greater likelihood of an acceptable outcome in Chinese GDP numbers. It is true that the country still has significant challenges, such as the reduction of large-scale debt mainly at State-Owned Enterprise (SOEs) and municipal governments but the service sector is burgeoning, with some of the most exciting consumer plays to be found in the fast-expanding internet sector. It is worth nothing that China surpassed the US as the largest e-commerce market in the world in 2013, * and by 2015 there were 413 million Chinese online shoppers. Long-term political trends encouraging Emerging markets are going through significant economic and social changes which drive increased voter activism and inevitably affect existing domestic political power structures. These changes have a direct impact on policy and consequently influence investment outcomes. For many countries in the asset class, the issue is the governments ability to execute on planned policy changes, given constraints that are political (lacking legislative majorities) or economic (deficits, unemployment or other nearterm problems that demand immediate attention). In most cases, specific political outcomes are driving investment returns in the short term. This is true of Brazil, where the stability and effectiveness of the Temer coalition depends as much on the widening investigation into illegal party financing as it does on its economic policies. Nonetheless, the improvement in the policy outlook compared to the country s previous administration has fuelled a 63% rise (in US dollar terms) in the stock market in the first nine months of the year. investors appear to have accepted that China is not going to have a hard landing In some cases, the election results of a major trading partner dominate the policy outlook. At the time of writing, this applies particularly to Mexico, where the government finds itself constrained by the rhetoric ahead of the US presidential election. A victory by the Republican candidate would certainly be viewed negatively by investors in Mexico, but also in other markets, as it would be interpreted as negative for global trade and consequently for global growth. Looking to the medium term and beyond, however, the increased domestic voter activism that we see in emerging markets is a positive influence, as it will lead to stronger institutions and better functioning societies, in turn improving business environments. Brexit represents an external political risk to global trade and growth, but for the emerging market asset class, it is negative, rather than catastrophic. Investors are rightly concerned about potential trade protectionism, while economic and political uncertainties may conspire to delay capital expenditure decisions. In the short term, Brexit increases the pressure on central bankers to keep rates low. Longer term, however, certain emergingmarket EU countries could be beneficiaries of foreign direct investment flows from non-eu companies looking to replace or complement their existing manufacturing base in the UK. In the auto sector, for example, the Czech Republic and Poland, with their skilled auto workforces and lower costs look like promising alternatives. For their part, Asian emerging markets appear relatively insulated, while the importance of Chinese and Indian economic growth becomes even more relevant for global markets. *Source: emarketer, July Source: CNNIC, 37th Survey Report, Source: Factset, September 2016.

4 active VIEWPOINT: GLOBAL EMERGING MARKETS US interest rate cycle The consensus among investors now appears to be that the pace of rate rises in the US will be slower than initially expected. Although recent Fed minutes imply a rise is coming, it is clear that the Federal Open Market Committee (FOMC) would like to see more evidence of a robust recovery in the US and lower risks to global growth before proceeding. Traditionally, investors have viewed increasing rates in the US as wholly negative for emerging markets, as it strengthens the dollar and therefore makes debt denominated in this currency more expensive to service. In fact, it is not that clear cut, because the rise in rates is overwhelmed by the increase in growth, in the early stages of the rate cycle. It is only when growth is weakening that the rate rises are negative. Logically, investors now seem to have factored in a degree of pragmatism on the part of the Fed, in terms of the scale and frequency of future interest rate moves. These are likely to come with evidence of stronger economic growth. For emerging markets this constitutes a bit of luck, with further quantitative easing (QE) coming from Japan and the European Central Bank (ECB), which drives down global yields. The result has been significant investment flows into higher-yielding emerging market debt, which puts upward pressure on currency rates and sovereign bond prices all welcome news to emerging market central banks that want to cut rates. Rate cuts are to be expected virtually everywhere in these markets, except for Mexico, India and Philippines. In South Africa, the rate hike expected by the market will probably be delayed until next year. The currency angle Having been sold off aggressively in 2014 and 2015, emerging market currencies have now stabilised, taking the pressure off governments and central banks that would like to ease. For international equity investors, this is another positive consideration, as currency has historically been a significant factor influencing their investment returns from the asset class. On a realexchange-rate basis, emerging market currencies do not look stretched, even after the recent portfolio inflows into sovereign debt. Currencies of high-yielding countries, including Indonesia, India and South Africa, look to be supported by debt inflows. And countries with current account surpluses and improving fundamentals, including Mexico, Hungary, Taiwan and Korea, also appear to have underpinned their currencies. Consensus indicates that the Polish zloty and the Argentine peso will remain most exposed, with the Russian rouble dependent on the trajectory of the oil price and the Brazilian real on the effectiveness of the new administration s economic policies. Fund flows have started to turn Over the last four years, there have been sustained negative fund flows out of emerging markets. A sharp reversal of these withdrawals since June 2016 would seem to indicate that sentiment towards the asset class is finally turning. Over the last six years, developed markets have been attracting investment flows to the detriment of emerging markets. Now, in a world of freshly lowered growth expectations, corresponding low interest rates, and yet inexorably rising demand for returns on investment, the time is ripe for a reappraisal of the long-term opportunities that emerging markets present. Valuations this time is different It is conventional to make calls to invest in emerging markets when valuations are distressed. Many observers say they are waiting for this to happen, in order to trigger an allocation. We are convinced that this is a mistake, because we do not believe that these distressed valuations will materialise. The principal reason is that these countries are not in that position this time round. The last time emerging markets were generally distressed was in the aftermath of the Asian financial crisis and the Long-Term Capital Management hedge fund collapse, in During that period, it was common to see countries with deficits of over 10% of GDP and currency pegs to defend. This is no longer the case. The most extended countries now are small in number (Brazil, Turkey and South Africa) and there are no pegs left. Meanwhile, government debt has decreased significantly, rendering country fundamentals much more robust. Logically, investors now seem to have factored in a degree of pragmatism on the part of the Fed, in terms of the scale and frequency of future interest rate moves.

5 PAGE 5 Changes in the composition of the emerging markets benchmark Another factor to bear in mind is that the composition of the most widely used emerging markets index MSCI has changed significantly over recent years, as shown in the accompanying charts. Note the collapse in the materials and energy sectors, and the 130% rise in the weighting of the technology sector. There is a corresponding impact on all profitability and valuation ratios for the asset class, as companies in heavily-indebted, lower return-on-equity (ROE) sectors with excess capacity have become less relevant, while those with higher ROE and stronger capital structure the new economy beneficiaries of the growing middle class across emerging markets have achieved greater prominence in the index. Country weightings 2008 and China Taiwan S. Africa Israel Other Korea Russia Mexico Indonesia Brazil India Malaysia Thailand Sector weightings 2008 and China India Mexico Indonesia Korea Brazil Russia Thailand 14.9 Taiwan S. Africa Malaysia Other 26.5 the composition of the most widely used emerging markets index MSCI has changed significantly over recent years, as shown in the accompanying charts. Note the collapse in the materials and energy sectors, and the 130% rise in the weighting of the technology sector Financials Telecoms Industrials Energy Technology Utilities Materials Consumer Healthcare Financials Energy Industrials Technology Materials Utilities Consumer Telecoms Healthcare Past performance is not a guide to future returns. Source: Martin Currie as at 31 January 2008 and 31 August The bottom line for investors is that the asset class is optically at around the long-term average price-to-earnings level, but this is misleading for the reasons outlined above. Meanwhile, ROE is bottoming and price-to-book values remain low relative to history and the MSCI World index, which is representative of developed markets. Price to book over 10 years Return on equity over 10 years Price to book (x) MSCI World MSCI Emerging Markets 18 MSCI World MSCI Emerging Markets Return on equity (%) Past performance is not a guide to future returns. Source: Martin Currie and FactSet as at 31 August 2016.

6 active VIEWPOINT: GLOBAL EMERGING MARKETS Conclusion The backdrop for emerging market investors now appears to be turning and we believe the negativity surrounding the asset class has been excessive. Valuations are not low, but we continue to find ideas where we can build conviction for the long term. Importantly, we are not sliding down the quality scale in search of cheaplooking stocks, but remain focused on companies with proven track records and real longevity. As long-term fundamental investors, we continue to find attractive opportunities in every sector and region, irrespective of the prevailing conditions. Moreover, this environment of macro-driven uncertainties helps to underline the benefits of a diversified stock-focused portfolio based on in-depth research and regional expertise, rather than one dictated by macro factors or market-directional thinking. Uncertainty may be the enemy of investors, but looking beyond the short-term noise, we believe that there are great opportunities in emerging markets with many businesses that can compound returns way into the future. Uncertainty may be the enemy of investors, but looking beyond the short-term noise, we believe that there are great opportunities in emerging markets with many businesses that can compound returns way into the future. active VIEWPOINT is just one part of our range of investment materials. To access further perspectives on our strategies and key investment themes, visit: Find out more For further information on Martin Currie or our strategies please visit our website You can find your local contact at Or please call our global offices, press office or global consultant team on the numbers below: Edinburgh (headquarters) 44 (0) Asia and Australia (61) London 44 (0) New York (1) Media 44 (0) Global consultants 44 (0)

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