Emerging markets, which have attracted investors for decades, are having a tough year with growth down nearly 15 per cent amid growing concerns about the possible fallout from a trade war between China and the US, and the threat to capital inflows as the US continues raising interest rates.
But the long-term potential for capital growth from large populations and fast growing companies continues to offer compelling arguments for some exposure to the sector in a balanced portfolio, despite the high volatility and rolling crises that routinely rock markets around the globe.
For example, Macquarie Group’s next chief executive Shemara Wikramanayake says Australian investors should be looking at investment opportunities in India as they outgrow the local market, despite the difficulties of doing businesses there.
Wikramanayake, who was recently announced as the investment bank’s CEO-designate, noted Australia was a “$1.5 trillion economy in an $80 trillion world”.
The MSCI Emerging Markets Index is down 14.6 per cent and individual markets, such as Vietnam, have fallen 25 per cent in three months and Turkey is down more than 40 per cent since late January.
Digital darling Facebook’s 20 per cent single-day rout in July compares to China’s Tencent, a company that specialises in internet technologies, whose share price has plunged by about $143 billion since January highs, or three-times faster than its index benchmark.
China’s ICBC, a state-owned commercial bank, China Construction Bank, Ping An Insurance, Bank of China and Alibaba, an online commercial group, have all lost more than $50 billion of value so far this year, and even reliable Samsung Electronics has shrunk by $67 billion.
But does this mean that, after a period of strong performance and heady valuations, it is a good buying point? And if so, how should investors gain exposure – and where is the value?
Search for value
The premise of emerging market investment is that it exposes an investor to growth stories not possible in the developed world.
The IMF’s World Economic Outlook for April 2018 put real annual GDP growth in emerging markets at 4.9 per cent, compared to 2.5 per cent in advanced economies. In China and Vietnam, it’s 6.6 per cent, in India, 7.4 per cent, in Ethiopia, 8.5 per cent.
The problem is that emerging market share prices, even those that track broad-based indices, don’t automatically follow national GDP growth.
Emerging market shares behave in a much more volatile manner than those in the developed world, and are exposed to macro events beyond their – and investors’ – control. Performance can be very good or very bad and is frequently both in the same year.
“The problem with emerging markets is they can look like a screaming buy, but they have to be looked at not just in terms of their own fundamentals but the macro context,” says Kris Walesby, chief executive of ETFS Management. “That is such a big driver.”
Concerns about a trade war
Right now, the main concern is the rhetoric around trade.
“The dominant emerging market story currently is the developing trade war between China and the US, and that is clearly concerning markets,” says Archie Hart, strategy leader for emerging markets equity at Investec Asset Management.
It particularly concerns emerging markets because most of them are net exporters who clearly don’t benefit from a mood of nationalism and protectionism.
The problem is, it’s a very difficult situation to read, according to analysts.
“We have a situation where the American president and his administration start off incredibly aggressively in any negotiation, and then tend to back-track,” says Hart.
“This is a negative environment for the market, but worst-case scenarios are probably not central to what we expect,” he says.
Rising interest rates
Analysts claim it is easier to form a view about the problem of rising interest rates.
The US Federal Reserve is amid a rate-hiking cycle, the only question being how many hikes will come and over what time frame, and most of the rest of the developed world is either doing the same or expected to do so.
In this environment, money tends to seek safe havens like the US. By early July, emerging market stock funds had faced $9.36 billion of redemptions in four weeks and emerging market bond funds had 11 consecutive weeks of net withdrawals.
“As a group I suspect emerging markets will continue to struggle on the view that the Fed will keep raising rates and the US dollar will firm over the coming year,” says David Bassanese, chief investment officer at Betashares.
Kay Van-Peterson, global markets strategist at Saxo Capital Markets, says: “Is it maybe too early to get involved? As an inflation bull for the US, I feel the market is not giving the US interest rates the respect they need, which means more headwinds for emerging markets. My view is there’s still more blood on the streets to come through.”
Emerging markets embrace an extraordinary range of stories and dynamics.
As Van-Peterson puts it: the sell-off has not been symmetrical. And emerging markets themselves are not symmetrical.
At one extreme, there is Turkey, facing snap elections, a vulnerable economy and banking system, a 23 per cent drop in its currency this year and the prospect of US sanctions.
“It’s a situation where things are going to get dramatically worse,” Van-Peterson says.
At the other end there is Mexico, whose currency has strengthened and whose index is up 10.7 per cent from the start of June early August.
The dynamics that affect a Chinese bank are very different to the ones that affect a Chinese e-commerce leader.
Analysts can identify a host of macro conditions that apply to South Korea, but how do they then apply to Korea’s Samsung Electronics, which has manufacturing or sales operations in 80 countries?
“Good businesses can exist in bad postcodes,” says Nick Payne, head of emerging markets at Old Mutual Global Investors.
He cites the example of Brazil, where the economy is in deep recession and political system mired in scandal.
“Without crucial social security reform – retiring at 55 is the norm in Brazil – the country is heading for a debt crisis.”
But Payne likes Localize, Brazil’s largest car rental company, which is benefiting from growth in car leasing and is a good business with a strong balance sheet.
“As an example of a secular growth stock, the group’s profitability is driven by behavioural changes and not just changes in the economic cycle,” he says.
Old Mutual also holds the Turkish auto maker Tofas.
“Irrespective of short-term market volatility, the key, we believe, to successful investing is to buy quality companies at reasonable prices,” says Payne.
Active versus passive
Fund managers claim opportunities to invest in strong companies in weak economies strengthens the case for active stock pickers, rather than passive index tracking.
“This is an area where good active management to avoid the worst countries and companies makes some sense,” says Bassanese.
“South Korea has been one of the world’s cheapest markets for a number of years and we’ve continued to find more opportunities there than in most other markets,” says Peter Wilmshurst, portfolio manager at the Templeton Global Growth Fund.
In particular, the fund has been overweight Samsung Electronics ever since the bursting of the tech bubble in 2000, seeing a low-priced, low-cost company with a market-leading position and investment to stay ahead.
But Templeton, a value manager, is not buying into Alibaba, the Chinese online commerce group, or Tencent despite recent price falls.
“We’re not jumping out of our seats to buy Tencent,” Wilmhurst says. “It’s on 35-times 2018 earnings. For our tastes we would want to see more of a pullback.”
China, which dominates emerging market portfolios, is not in favour for many fund managers and analysts as it struggles to buffer the strains of reducing total debt by selectively injecting liquidity.
There is a tendency to wait and see how this works out before committing, analysts claim.
Some investors seek exposure to emerging markets through infrastructure in the belief that it will provide relatively high total returns with low correlations to traditional asset classes, such as equities, fixed income and real estate.
“Emerging markets are expected to grow rapidly over the next 30 years,” says Sarah Shaw, chief investment officer at 4D Infrastructure. “This growth is driving a huge need for infrastructure investment,” she says.
Asian Development Bank believes $1.7 trillion per year is needed in Asia between now and 2030. That compares with Australia’s gross domestic product of $1.2 trillion.
The drivers are a growing middle class and increasing urbanisation.
How to invest
Several fund managers offer emerging market equity funds to Australian investors, according to Morningstar, which monitors fund performance.
The best performing over the past 12 months to June 30 is the Legg Mason Martin Currie Emerging Markets Fund that has returned about 19.7 per cent, followed by MFS Emerging Markets Equity Trust and JP Morgan Emerging Markets Opportunities.
Some prefer Asia Pacific exposure over global emerging markets.
The best over the 12 months to June 30 include Fidelity Asia with a return of more than 22 per cent.
For those who prefer low-cost passive exposure through an exchange-traded fund, both iShares and Vanguard offer products tracking emerging market share indices such as the MSCI Emerging Markets.
Investors can also take direct exposure to individual stocks. Many Australian brokerages allow access to the Hong Kong exchange, for example, upon which many Chinese leaders are listed through what are known as H-shares (Tencent being a prominent example).
· Some investors prefer to gain exposure to emerging markets through western-based companies with much of their business in the emerging world, such as Coca-Cola, Apple or Volkswagen. Australian stocks with major emerging market exposure would include the diversified miners, Rio Tinto and BHP Billiton, though naturally their performance will depend on the behaviour of commodities as much as emerging markets.
. Listed funds can provide exposure to infrastructure investment. Most of the major fund management groups and investment banks have offerings.
Old Mutual’s Payne claims the outlook for the sector remains promising, despite problems in some major markets.
“Global growth is still reasonable,” he says. “The inflation backdrop is benign. For now, the emerging markets profits cycle remains intact and opportunities are starting to present themselves.”
Justin Preston, head of equity at bfinance in the UK, says demand from investors seeking some long-term capital out-performance also remains robust.
“Much is being driven by attractive relative valuations,” says Preston, who adds that some investors have seen their emerging markets allocation drop and want to rebalance their portfolios.
Preston says clients are favouring active over passive management, and value investors looking for undervalued stocks, rather than growth investors hunting capital appreciation.
He says clients favour Asia because of concerns Latin America and Eastern Europe are too risky.
“With Asia representing 75 per cent of the MSCI Emerging Market Index, an investor can capture emerging economy dynamics by focusing their attention here,” he says.
Signs of recovery but risks remain
A sudden major change in the rhetoric around a trade war would herald a market turnaround, claims Templeton’s Wilmshurst.
“That’s the most critical,” he says. “China is the country most directly in the crosshairs but if you think about the Chinese export machine for computers, smartphones and so on, that relies pretty heavily on a number of other countries in the region.”
Van-Peterson, who today considers that “everything linked to the China, Korea and Taiwan supply chain is kryptonite and I’m staying clear of it”, adds it is “worth keeping them on your radar. If the market feels there is any turnaround on trade developments, these will be the areas that bounce the most.”