The evolution of emerging markets
For many years, emerging markets have been a popular and generally successful investment choice for international investors. However, the emergence of economic and political headwinds and poor recent market returns have led to questions about the attractiveness of emerging market equities. In this article, we explore the factors behind this shift in attitudes, and look at the current pros and cons of this asset class.
The boom phase
Historically, the main drivers for allocations to emerging market equities were an increased recognition that their inherent risk was declining and that their growth would meaningfully outstrip developed market growth. Improvements in macroeconomic management from the lessons learned during the 1998 Asian crisis saw an increase in the credibility of many emerging market governments and central banks. This persuaded credit rating agencies such as Standard & Poor’s and Moody’s to upgrade the debt of a number of countries from ‘junk’ to investment grade status.
At the same time, emerging markets delivered rapid growth through the better use of technology, greater levels of investment, demographic shifts, and increased opportunities to export products to the developed world and import jobs from the developed world. Cheap labour and competitive currencies supported strong export growth. Also, powerhouses like China spread the benefits of growth by importing vast quantities of raw materials from commodity-producing nations, such as South Africa, Russia and Brazil.
Current returns are looking bleak
The progress of emerging market economies was so impressive that when the financial crisis hit in 2008, many analysts suggested that the economic dynamics of developed and emerging markets could ‘decouple’ to reflect the fundamental strengths of emerging markets. This could allow them to continue to thrive while developed economies struggled to extract themselves from the aftermath of the crash. Indeed, in the darkest days, the world looked to China as a potential engine for global recovery and a beacon of strength. The Chinese responded with a massive stimulus programme at a time when few other nations were in a position to contribute much. However, since the emerging market story started to turn sour, all that seems a long time ago. The table below shows just how stark the change in the relative performance of emerging markets has been lately.
Quantitative easing exposes emerging market currencies
The developed world’s cure for deflation and debt overhang following the financial crisis has been near zero interest rates, supplemented with a liberal dose of quantitative easing. While helping the West, quantitative easing accentuated imbalances in many emerging economies. Countries like South Africa and India have experienced current account and inflation problems, while the legacy of a massive infrastructure building programme and a credit explosion in China also necessitated adjustments. This has inevitably led to a growth slowdown, with negative knock-on effects on countries reliant on supplying China with raw materials. Add to that uncertainties over an unusually high number of national elections (India and South Africa), growing political and social unrest (Turkey, Thailand and Brazil) and regional tensions (Russia and Ukraine), and it is understandable that investors have become nervous. However, it was the US Federal Reserve Chairman Bernanke’s speech in May last year, when he first made serious mention of reducing quantitative easing, that really sparked fears about the impact of tightening liquidity and higher borrowing costs on countries running large current account deficits. The chart above shows just how dramatic some of these currency movements were in 2013, by plotting the movements in various emerging market/US dollar exchange rates against their current account balances.
Emerging market currencies are more competitive
In response to the attack on their currencies, many emerging market central banks raised interest rates, which had the side effects of dampening domestic demand and slowing growth further. In many respects higher interest rates only worsened the situation as it led to further downgrades to short-term growth expectations and an acceleration of capital outflows.
However, there seems to have been an improvement in the last few months. Emerging market equities, bonds and currencies have all shown tentative but encouraging signs of recovery. Economic growth downgrades have slowed, and some of the negative sentiment has dissipated. After falling steeply, many emerging market currencies have now stabilised, and we think they are currently cheap. From this perspective, emerging markets are now an attractive investment opportunity. On the one hand, if these exchange rates were to stay at such depressed levels, they will eventually support a re-acceleration of growth. On the other hand, any recovery would boost returns that international investors receive from allocations to emerging markets.
Good value in their own right
Currencies provide one reason why emerging markets might now be offering investment potential. In a world where attractively priced opportunities are getting harder to find, emerging market equities also appear to offer good absolute and relative value in their own right, having materially disappointed over a sustained period.
The chart above demonstrates how the gap between the forward price earnings (PE) multiple has opened up in favour of emerging markets over developed markets during the last few years.
Real growth prospects are looking favourable
In addition to the valuation case, we also believe that the ‘relative growth’ argument still favours emerging markets. The difference in real growth between emerging and developed markets has narrowed lately, but looking forward, the advantage still lies with the less developed economies. The chart below demonstrates this, using historic and projected data published by the IMF.
Emerging markets deserve a place in an international portfolio
The cyclical slowdown in emerging market growth is a significant change from what we had become accustomed to in the last decade. In our view, many of the longer-term structural tailwinds that drove better economic performance and stronger market returns in emerging economies remain in place. Shorter-term cyclical pressures that necessitate policy adjustments just currently obscure them. We expect to see emerging markets eventually reassert their strengths by harnessing the potential of lower government debt levels, better demographic trends, expanding middle classes, increasing urbanisation and more intensive use of technologies to re-establish stronger growth.
Because we view many of the current pressures weighing on these countries as normal cyclical factors that all economies face from time to time, we regard current emerging market levels as attractive when compared to other opportunities. We therefore believe that there is a strong case for including an overweight allocation to emerging markets within any international portfolio.
