It’s been a challenging few months for emerging markets (EM). Unsurprisingly though, as active fundamental managers we see the dislocation between negative market reactions and the actual long-term drivers of growth in the asset class as a compelling opportunity.
We believe EM still represents good value in terms of an international equity allocation. Return on equity is fairly synchronised with developed markets, as represented by the MSCI World index, however, price-to-book and price-to-equity values remain low relative to history and developed markets as the following charts show.
A Divergent Price to Book Value
Source: Bloomberg as at 30 September 2018.
And Yet A Similar Return On Equity
Source: Bloomberg as at 30 September 2018.
Turkey’s currency crisis in early August prompted an all-too familiar set of headlines. A predictable news flow was eager to foretell that the crisis would deepen and inevitably spread across the entire asset class. As is usually the case, ‘contagion’ quickly became the must-use word for every EM commentator.
This customary, knee-jerk reaction prophesising that EM turmoil will develop from an adverse situation in one of many differentiated EM economies is, in our opinion, not only wrong, but an outdated view of the asset class.
In previous bouts of EM turbulence, investors have often been quick to ditch the asset class, making little distinction between individual regions, governments, economies or companies. It’s a response which continues to have a lingering legacy, even though compared with any other point in history, EM countries are more stable economically, more independent of each other and increasingly diversified. Times have changed and economic vulnerability (leading to contagion) in emerging markets has significantly lessened. What’s more, investors are also gradually becoming more aware of the different drivers between individual markets.
No two situations are alike
For instance, during the recent currency weakness in emerging markets several varied factors have been at play. In Turkey, the crux of the recent problem has been a substantial pickup in inflation, as well as relatively high foreign-denominated debt and a current account deficit, with the backdrop of some unorthodox policy moves not helping matters either.
By contrast, in Argentina (which is not yet part of the MSCI Emerging Markets index), circumstances are very different. The government tried to implement an ambitious fiscal adjustment that depended on constructive global markets and increasing Foreign Direct Investment (FDI). Unfortunately, the FDI did not materialise and markets became much more nervous, coinciding with some policy mistakes. However, the situation has been stabilised by an IMF credit line and interest rates at 40%.
South Africa, meanwhile, has also experienced currency weakness, forcing the monetary authorities to raise rates. The greater issue there is politics – in particular, the coincidence of a weak economy and the reforming agenda of new president, Cyril Ramaphosa, as he looks to break the back of the existing corrupt power structures in the ruling African National Congress.
Fundamentals stronger than ever
We should not downplay the seriousness of the situations these countries face – we believe recessions in Turkey and Argentina are all but guaranteed. However, the currencies in question have largely stabilised (albeit it at much lower levels) and it is noticeable that wider contagion across emerging markets has not materialised. In Mexico in fact, although not widely reported, the peso has actually strengthened against the US dollar.
Of course, the rising US dollar that we have witnessed recently does have implications for countries where US dollar-denominated debt is high, such as Turkey. Yet, for many emerging markets that dependence on external funding has dropped significantly. Domestic bond markets have developed and provide a greater source of financing for EM governments and companies. Sovereign balance sheets are consequently in far better order than they were even five years ago, with debt-to-GDP levels lower and debt increasingly denominated in local currency.
In short, emerging market fundamentals are stronger than ever and talk of contagion, particularly now, seems overdone.