As slowing growth depresses emerging market valuations, Joseph Mariathasan argues that this might be the time to adjust strategically for the new, long-term growth and risk paradigms
Emerging markets are in the midst of a transition from a satellite or tactical exposure within institutional portfolios to a core component. But there is still a gap between the perceptions of emerging-market risk and the apparent reality – which might be reflected in the fact that emerging market sovereign debt has generally become an investment-grade asset class and now trades at much lower spreads than it has historically.
Alan Dorsey, head of investment strategy and risk at Neuberger Berman, argues that it is possible that this risk premium compression is secular, not cyclical – a one-time transformation in the perceived ‘riskiness’ of the emerging-market debt asset class.
“If so, it is possible that emerging-market debt is a canary in the coal mine for the emerging market equity-risk premium,” he suggests. “Emerging-market equities could be on the precipice of a similar one-time risk-premium change. Like the changed spreads on emerging-market debt, reductions in equity-risk premiums won’t happen overnight, but in five years’ time, investors may recognise there has been a sea-change.”
Dorsey sees key issues that still need to be addressed, to varying degrees, in many emerging markets – corruption, insider dealing, corporate fraud. But there are powerful factors pushing societies to tackle these remnants of a passing age.
“Governments keen to develop their capital markets and local entrepreneurs who want to monetise their assets realise that it is in their own interests to tackle these problems to attract the permanent support of international investors,” Dorsey reasons.
Today could present a unique opportunity to overweight emerging market equities in strategic asset allocations. The current timing is particularly attractive as emerging markets have been underperforming over the past couple of years and continued to fare badly relative to developed markets in the risk rally seen during 2012. Valuations in Asia are at the bottom of their 10 to 20-year trading ranges, and Dorsey says that Neuberger Berman has seen sophisticated institutional investors such as endowments investing in its China fund, taking advantage of a pause in China’s growth story to add exposure even while China has fallen out of favour with retail clients.
But beyond that big decision, understanding to what extent investing in emerging markets is a play on domestic demand growth might have a bearing on what the investment strategy should be.
One reason for the recent underperformance is that the theme of domestic demand replacing exports of cheap goods and labour still has a long way to develop. This is one reason why China continues to be the main fulcrum of emerging market dynamics – it is the key importer of commodities from the likes of Brazil and Russia (and these three countries account for 40% of the MSCI Emerging Markets index), and the key importer of manufactures from Korea and Taiwan.
“Even in Brazil, where commodities account for less than 10% of GDP, the majority of investment growth over the last decade has been driven by the commodity sector with more than 50% accounted for by mining and energy,” notes Maarten-Jan Bakkum, global emerging market equity strategist at ING Investment Management.
Emerging markets have yet to decouple from China, from one another – or from the developed world.
“Although emerging markets have high growth rates, when the US and Europe slow down, so do they,” says Keith Wade, chief economist at Schroders. “Most emerging market economies are still dominated by commodity exports –Latin America, for example – while eastern Europe is dominated by what happens to the Russian economy.”
And it is not just the economic slowdown in the developed markets that has had a negative impact on emerging markets. Wade sees the de-leveraging of the banking sector in the US and Europe as a factor, too – as they pull money from the region, falling liquidity puts downward pressure on the markets.
This can be frustrating for those working in emerging markets. “I was in Hong Kong in early 2012 and all everyone wanted to talk about was Greece,” recalls Robert Horrocks, CIO of Matthews Asia, ruefully. “Yet the size of the Greek economy is miniscule relative to China’s and whether or not Greece defaults is irrelevant to China’s economy.” But at the same time, it has to be acknowledged that much of the blame for the recent malaise of emerging market equities can be laid fairly and squarely on China, whose economy remains closely coupled to the fortunes of its customers in the US and Europe.
While China’s economy, by common agreement, is flying higher than most, that does not stop commentators worrying about whether it is heading for a ‘hard’ or ‘soft’ landing .
“Investors are worried that long-term growth in China will be closer to 5% rather than the 8%-plus levels we have got used to,” says Bakkum. “That changes the whole environment for emerging market growth and is the reason why emerging markets have lagged developed market equities over the past two years.”
While recent months have provided increasing evidence that the Chinese economy is picking up into a cyclical recovery, that recovery is likely to remain shallow: “The banking system and local government finances cannot handle a credit injection as aggressive as in 2008-09,” says Bakkum. “The problem of financing is the main reason why the stimulus this time will be less. Banks are feeling the pressure of rising non-performing loans and slowing deposit growth.”
But of course, this slowdown – or rather, transition – is a managed one. It is itself part of the longer-term story of consumption growth, a long-term story for emerging markets that the past couple of years has done nothing to change. While these economies have always experienced cyclical ups and downs, many now appear more structurally sound, partly thanks to an increase in the foreign currency reserves built up through exports of commodities, manufactured goods and competitive, low-cost labour.
Between 2000 and 2010, Asian central banks accumulated $3.5trn of foreign currency reserves (China alone accounted for $2.3trn). And global emerging market foreign exchange reserves stood at $6.8trn at end of 2011, twice the amount held by developed countries. Inflation has also declined dramatically as those central banks have adopted inflation-targeting monetary policies. GDP growth is set to be four times greater than that enjoyed by developed markets in 2013: emerging markets’ share of global GDP has grown from 21% to 36% in the last decade and the IMF forecasts that it will be over 40% by 2015. That economic growth is finding its way into infrastructure expenditure and raising income levels, in turn creating a growing middle class that is increasing its consumption, transforming economies from their dependence on exports.
GMO chairman Arjun Divecha points out that savings rates usually rise until countries reach a GDP per capita range of $3,000-10,000, at which point consumption becomes a larger part of GDP growth as society starts to provide a social safety net – and per capita consumption of all goods and services rises in a highly non-linear fashion. For example, while Chinese per capita GDP quadrupled from $1,000 to $4,000 during the past decade, auto sales rose from 1m vehicles per year to over 17m. Half of all emerging markets (by market capitalisation) are now in this sweet spot of shifting from savings to consumption – and markets rarely anticipate this kind of non-linear growth.
Further strengthening the economic case is a shift in demographics: a record number of people are coming into their earning years in emerging markets at the same time that baby boomers are starting to retire in the developed world. As a result, Divecha argues, the world is in the midst of “a massive shift in demand from the developed world to emerging markets”.
In line with that story, exposures to emerging markets are increasing across the developed
world – and have been for many years. But while many investment consultants and asset managers argue that investors should at least match the 12-13% weighting of emerging markets in the global universe, and many would advocate significant overweight positions, this goes beyond what is generally practised.
“We would suggest a mild overweight position of 15% of equities in institutional portfolios,” suggests George Hoguet, global investment strategist at State Street Global Advisors.
“But most funds have half that figure and in some countries like Japan and Germany it is even less.”
The tendency to underweight emerging markets is exacerbated by the fact that any capitalisation-weighted benchmark can lead to a severe distortion of the allocation away from that which a more forward-looking analysis would suggest.
“A backward-looking market-capitalisation approach would heavily underweight Asia-ex Japan relative to economic activity,” says Horrocks. “As a result, we are seeing demand from both institutions and individuals for our China and India funds so that they can move their own exposures closer to what the growth prospects and GDP would suggest as appropriate weights. Clients are now taking a more strategic view of Asia and have moved it from a satellite position to core. That has been the biggest change of attitudes that we have seen over the past three years, and it is fundamentally different from another change in economic views of Asia.”
Thought leaders in this trend are the usual suspects – US endowments and some of the younger, less constrained pension funds. And it does take a sophisticated approach – transforming emerging markets into a core component of institutional portfolios does raise significant questions.
Lumping all emerging markets into one asset class with frontier markets in another is an artefact of index construction with little fundamental rationale, for example. The MSCI universe of emerging markets is dominated by the BRICs, Taiwan, Korea and South Africa (80% or so of the total), leaving investors with little opportunity to gain exposures in a host of fast-growing, medium-sized markets. Cap-weighted indices in general are dominated by larger, export-oriented companies, leading to much less exposure to the key domestic growth story than investors might realise.
“The investment universe should be as broad as possible and include markets like Chinese A shares and emerging market small-cap stocks, where coverage is very patchy but which are much more focused on domestic demand,” suggests Hoguet.
Frontier market indices can be even more misleading: it is difficult to conceive of the rationale that groups together a market like Bangladesh (representing one of the world’s poorest economies) and one like Qatar (which is richer than much of Europe).
The structural approach to emerging market investment will have to change and, in particular, move radically away from the market capitalisation-weighted approach of traditional indices. China and India have such a global importance that they merit attention on their own rather than being lumped with 20 or so other countries as a single asset class.
Horrocks at Matthews Asia sees it as inevitable that China will be seen as a separate investment destination in its own right, alongside Japan and the US: “Investors will start seeking China value strategies, or China growth or small-cap,” he predicts. India may also get there, but at the moment it is harder to differentiate that market in terms of strategy and style: “There are not enough high-yielding stocks for income strategies, and liquidity is too low for small-cap strategies, for example.”
Deciding exactly what emerging market investment actually represents might be the key to deciding on whether now is a good time to rotate more equity exposure into emerging markets, or whether it makes more sense to wait for a global valuation correction – perhaps in response to slowing US growth or a shock emanating from the euro-zone.
The reduction of emerging market risk, the growth of domestic demand, the economic arbitrage of lower wage levels, and the export of commodities, are each major factors driving emerging market investment, whether directly through locally listed equities, or indirectly through global multinationals. The factors are not dependent on each other but neither are they completely independent. What they do suggest is that focussing on a capitalisation weighted index benchmark of locally listed emerging market equities gives a very incomplete picture of the opportunities and also the risks and, as a result, relative valuations of emerging market and developed market indices may be a poor guide to predicting future performance.