Emerging Markets will experience some short-term pain in 2018, but the soundness of EM economies has never been stronger. See why our faith in the asset class remains unchanged and what's most important now in its major countries and regions.
News flows around emerging markets have been dominated of late by the opening shots in a trade war between China and the USA and pessimism over the future of the North American Free Trade Agreement (NAFTA). These have helped contribute to the highest volatility seen in the asset class for 4-5 years.
However, the metrics for EM economies are stronger than they have ever been.
- Very few EM countries have sovereign deficits higher than 5% of GDP; plus 80% of overall EM debt is now in the private market and not at the sovereign level and most of it is in local currencies, not in US dollars.
- Furthermore, no EM country has a dollar peg to defend on their currency, as was the case during the 1997 Asian Financial Crisis.
- Lastly, it should be noted that these countries are doing more business amongst themselves - 18% of global trade today is between emerging markets, whereas 20 years ago that was only 4%¹.
The latter statistic highlights our faith that the protectionism of the US will have less impact than some fear. Our analysis is that the US is unlikely to succeed in a trade war, as globalisation has gone too far and is too complex to unravel.
The outlook for this region is one of the brightest in emerging markets.
The relatively low level of inflation across many countries, compared to history, is a good indicator of that. This is attributable to a greater awareness of Asian central banks on how to manage their interest rate cycles. It is also due to food inflation being low after three good Monsoon seasons, which have seen sufficient but not excessive rainfall. The latter is significant as food prices are a bigger factor in the inflation basket for emerging markets than developed markets. We are also seeing gross domestic product widely rising.
One area of short-to-medium term concern is sentiment around companies in the technology global supply chain. Those involved in the manufacture of smartphones or the components that fit in smart phones are witnessing a short term pause in growth and a relative weakness in share prices. The chief cause is global smart phone penetration reaching such high levels that producers are now seeing only marginal or single figure growth. We think markets have over-reacted to this development and fail to see the potential from other trends in which these companies are taking part. The demand for high specification chips needed for self-driving cars and for other areas of artificial intelligence is an area of massive potential growth. Companies in the smart phone supply chain are making components for the servers needed to power cloud technology and internet of things too, which require increasing amounts of processing power. We see such demand as more than enough to make up for any short-term downturn in the pace of smart phone sales.
In terms of Asian geopolitics one of the most interesting trends is the commitment made by the Communist Party of China at its 19th congress in October 2017 to seeing wealth spread more evenly among the population and the regions. Such a measure, if successful, should bring greater financial and political stability to the world’s second largest economy.
There are contrasting outlooks for the two largest Latin America economies.
Brazil has emerged from its sharpest recorded recession (2015-16) with some style. Its main equity index, the Ibovespa, has risen 125% from lows in January 2016 to May 15th 2018². Over the same time frame inflation has fallen from a peak of 10% to 2.7%, while interest rates have fallen from 14% to 6.5%. We expect growth of around 3% over the next 12 months and rising employment too. Not surprisingly, we are hearing that businesses are more confident to invest. Much of this is a domestic story, as only 20% of the Brazilian economy is export based. It is our view that the market has overplayed the downside risks in Brazil; we are more optimistic.
Our key area of caution is the general election in October. In theory, the incumbent government should be popular given the health of the economy, but centre-right President Temer has had single digit approval ratings after two impeachment attempts. Leading candidates in the election sit both on the left and the right and the result could mean an end to reforms going forward.
The outlook for Mexico, the next biggest economy in the region, is less positive. Mexico has been run on an extremely orthodox macroeconomic basis since the 1994 Tequila Crisis, but that could change if the leading figure in the polls, Andres Manuel Lopez Obrador, is elected as president in July. Obrador plans greater social welfare spending, protectionism on trade and is threatening to curb the scope of private companies in areas that have traditionally been dominated by the state such as energy production. Another question mark for investors is the survival of the North American Free Trade Agreement (NAFTA) in its current form. Given the shared protectionist stance of President Trump and Obrador, a weaker, diluted version might be expected. We think markets have underestimated the risks of this to Mexico; its currency has not yet fully reflected a weaker NAFTA agreement and the consequences of political change. Over the longer term, if NAFTA is not renewed or is diminished, the country will be less synchronised with the US economic cycle and will use its membership of the Trans Pacific Partnership to diversify its export markets away from the US. Clearly it will take time, but Mexican unit labour costs in manufacturing are on a par with China’s and Mexico has developed a skilled workforce and a strong logistics infrastructure over the last 24 years of its NAFTA membership.
We expect to see improvement in South Africa, but we are more cautious than consensus that the election of President Cyril Ramaphosa is a turning point. The economy has suffered from a decade of mismanagement and a president committed to fighting corruption means a big dark cloud of bad governance will likely be lifted, but there are still challenges. The price of the commodities, which form a large part of South African exports, are not rising and there are big debts that need to be managed. Ramaphosa has a Rolodex of personal connections with which to reconnect SA with global investors in a credible way, but he has to undo the structure of the past 10 years first.
Three key emerging European economies -- Czech Republic, Hungary and Poland --all stand to benefit from a reactivation of European growth and should see growth above 4% for the next 12 months. One key metric of how they benefit from European growth is the calculation that a 1% increase in industrial output in Germany leads to a 0.6 to 0.8 increase in output for Czech Republic, Hungary and Poland. Our focus in these countries is on opportunities from banks that are financing and benefiting from the expansion of growth.
Russia’s economy has suffered from four years of international sanctions, which has made the yield on equities the highest in emerging markets and has given it a cheaply valued currency. Our focus here is on domestic companies that have adapted to this environment, particularly those that are benefitting from import substitution – where a domestic producer ramps up production and standards to compensate for the absence of competing imports. We are avoiding state-owned enterprises or companies [KL1] which have suffered from new targeted sanctions from the West in 2018. The recent re-election of President Putin means the tension between Russia and the West looks set to continue, but in pragmatic terms it does give stability to investors who know what to expect.
Although near term there are challenges with sentiment, we are confident that the economies and corporates in emerging markets offer exciting, selective opportunities for active managers.
¹ Source: Martin Currie and Statista. Statista sources: IWF, WB, WTO.
² Source: Bloomberg