Emerging markets (EM) had a volatile 2018, marked by a 17% contraction in the MSCI EM Index and a 24% decline from the January peak.1
There are three key contemporary controversies that underlie the weakness in a global context:
- China’s growth deceleration
- The broad-based strength of the U.S. dollar
- Perceived structural fragilities in EM
Below, we endeavor to explain why these controversies have either run their course or have been misunderstood by the market. We will also examine the real options that exist in the asset class, and articulate the pivotal reasons why we believe the stage is set for a recovery in EM equities. In summary, we believe that:
- Structural reforms have the ability to fuel domestic investment and growth potential across a number of large EM economies
- China’s challenges are manageable and its opportunities greatly underestimated
- Many extraordinary companies are currently trading at highly attractive valuations
What Has Investors Worried?
1. China’s transitional challenges and slower growth weigh heavily on global equities.
With the Shanghai and Shenzhen indices down 29% and 36%, respectively, in 2018, challenges in China are the top concern on investors’ minds.2 While concerns about China’s growth meaningfully impacted EM sentiment last year – and volatility will likely persist for some time – we believe this issue is largely misunderstood. China’s economy is going through a period of big structural transformation, coming off an extended period of extremely rapid growth, and is moving onto a more sustainable development track.
Two key factors are responsible for China’s growth over the past three decades: export-led growth that drove massive gains at the beginning of the century and significant investment in the domestic property market, which fed off significant gains in real estate values. Both of these traditional growth drivers have faded drastically in the last five years.
Just a decade ago, China was running a nearly 10% current account surplus relative to GDP, a number that is now closer to 1%. Boasting an approximate one-fifth share of worldwide manufactured exports, China’s potential in that arena is essentially saturated, and its exporting prowess, which had long fueled supernormal growth, has largely gone away. With semi-skilled migrant wages at about U.S. $500 per month,3 the country is no longer competitive in low-end manufacturing jobs compared to places like Bangladesh and Vietnam. Instead, China is slowly gaining ground in higher value-added industries. Thus, trade has essentially become a growth detractor.
The real estate sector was the second key driver of China’s growth. High levels of domestic savings, coupled with a closed capital account and limited domestic financial investment options, sponsored a massive real estate boom. China’s property market, which has been the quickest path to wealth creation over the past two decades, is finally slowing down, after almost two years of government measures to quell speculation-driven price increases. Overall sales by floor area dropped 27% year-over-year during China’s Golden Week holiday in October.4 Amid a cooling property sector, property investment growth has also been weakening and developers have left a trail of failed land auctions – something that hitherto was almost unheard of.
There has been a notable build-up of leverage in the financial system over the last decade. Debt has increased spectacularly as China’s government has responded to weak external demand post 2007-2008 with consistent doses of credit to sustain growth. The government’s recent push to control risks from this excess debt has resulted in credit growth decelerating over the past 18 months. Most recently, there has been a deliberate curbing of shadow banking activities, with net new lending from this segment plummeting from 12% of total system credit in 2016-2017 to -9% in the first half of 2018. Typically, credit growth is a one- to two-year leading indicator for GDP, and we are already seeing the effects. The country’s ongoing deleveraging is simply incompatible with the levels of brisk growth to which investors have become accustomed.
Still, the high debt stock in China is not particularly worrying to us. Our confidence lies in two distinct characteristics of the Chinese economy: China’s excess savings and its fiscal capacity. The country’s stock of financial savings is unprecedented at over 400% of GDP at the end of 2015.5 Further, China has a particularly healthy public balance sheet with low levels of fiscal debt (contrary to the massive fiscal expansion in the U.S. witnessed over the last decade). These factors give the government an ample amount of capacity to recapitalize the banks and crack down on state-owned enterprise debt, while also providing stimuli in a surgical fashion, for example, through lower reserve requirements and consumption-boosting tax cuts.
2. U.S. dollar strength and rising rates hit EM currencies and spreads.
The normalization of U.S. monetary policy through rate hikes and the concurrent significant strength in the U.S. dollar have resulted in both increased volatility and weakness in EM equities. The U.S. Dollar Index DXY, which measures the strength of the U.S. dollar against a basket of currencies, has risen 20% over the past five years, and combined with rising interest rates, has resulted in money flooding out of emerging markets. And it must be remembered that, as the dollar rises, so does the local currency cost of servicing dollar-denominated debt, as has been painfully evident in places like Argentina and Turkey, both of which have experienced market meltdowns.
Fundamentally, this is not an EM equity phenomenon, but a worldwide strong dollar phenomenon. Alongside USD rate increases, we have witnessed a marked increase in bond spreads. For example, the average spread of EM sovereign bonds to U.S. Treasuries rose to over 415 basis points (bps) in January 2019 from about 280 bps at the beginning of last year.6 Likewise, the spread of global bonds, as illustrated by the JPMorgan Global Aggregate Bond Index, increased by approximately 60 bps last year.7However, looking at the next 12 months, the likelihood of continued dollar strength is extraordinarily low, in our opinion. First, the relatively expensive U.S. stock market is already signaling an end of a much-extended bull market. This has profound implications for EM equities, which have lagged the S&P 500 on a cumulative basis by approximately 42% in USD terms over the past five years.8
Second, U.S. growth will face significant resistance as fiscal stimulus evaporates and the current account deficit expands. There are already signs that high interest rates are restraining activity, notably in discretionary spending and housing.
Third, there is growing fiscal stress after the massive increase in the U.S. federal deficit over the past 10 years, compounded by unnecessary fiscal stimulus in 2018. Indeed, U.S. growth was effectively front-loaded thanks to tax cuts and the resulting repatriation of large corporate profits.
Last but not least, it is likely that the Fed will have to respond to the above with a much more dovish monetary policy than is currently anticipated. This essentially provides the context for the potential resurgence of EM equities.
3. Emerging market economic vulnerabilities are significantly overstated.
Alongside concerns about China growth and USD strength, structural issues in emerging markets have made investors excessively bearish. However, we believe these vulnerabilities are overstated. Contrary to conventional wisdom, there has been no significant increase in leverage in EM outside of China in a decade.
The "Fragile Five" was a term coined in 2013 to represent EM economies that were overly dependent on unstable foreign portfolio investment to support growth. But these economies (Brazil, India, Indonesia, South Africa, and Turkey) have changed dramatically from the days of the EM cyclical downturn in 2014-2016. Improvements in external balances have broadly taken place across EM. Turkey is one of the most interesting circumstances in that respect – within the past couple of quarters it has essentially eliminated one of the biggest current account deficits in the world, with sharply higher rates and a willingness to retreat into recession to repair its external balance.
Current account imbalances across EM countries have narrowed overall since the dark days of 2014-2016. Further, EM inflation is largely remote and rates have already adjusted. The real problem in the emerging world is not about external vulnerability, but rather about growth, which essentially ties back broadly to the low savings phenomenon across much of the EM world outside of China.
In Times of Stress, Big Opportunities Arise
In the following section, we further explore four key reasons why we believe the current environment is an opportune one for EM investors.
1. Structural reform is coming to an emerging market near you.
First, we expect material structural reform across the developing world, particularly in places like Brazil, India, Turkey, and Mexico. This involves improving the supply side of growth through policy changes. Having spent time in Brazil and Turkey recently, we see clear evidence of a willingness in government and society to undertake material hard decisions to improve growth potential structurally. Structural reform can lead to improvements in savings capacity, which will in turn fuel domestic investment and growth.
Take Brazil as an example. Enthusiasm for newly elected President Bolsonaro is evidenced by the recovery in the Brazilian real and equity markets. The opportunity for reform to address the economy’s two fundamental problems is percolating. The first concern is insufficient domestic savings – Brazil does not have enough domestic savings to support growth. Second, structurally unsound fiscal balances – a large part of that low savings is not being put into productive capital stock, but rather, is funding huge fiscal deficits. Re-channeling those savings into productive assets can have a profound effect. There is a big opportunity for Brazil to open up its economy, akin to Mexico with NAFTA. This would pave the way for potentially spectacular foreign direct investment-led growth. And while this would damage protected domestic industries, it is a necessary step as the whole country would benefit.
Similarly, India is another country counting on cumulative reforms to increase its growth potential. Measures such as a goods and services tax (GST); establishment of bankruptcy laws; and recapitalization and cyclical repair of bank balance sheets have already occurred, sowing the seeds for future growth. As India shifts large swaths of the economy into the organized sector, productivity and savings gains can amplify growth potential. India has a pronounced dual economy, with a relatively small but highly productive formal sector complimented by a huge, but insufficiently productive, unorganized sector in agriculture and domestic services. Successful labor reform would pave the way for India to take all those China-plus jobs that have found their way to places like Indonesia, Vietnam, or Bangladesh.
The scale and impact of China’s ongoing structural reform is unparalleled. Committed to its transition to a consumption- and services-driven growth model, China had entered a new era of economic development. Its export economy, which was all about “stack ‘em high, sell ‘em cheap” manufactured goods, hasn’t been a growth driver for 10 years. The growth in the economy is slowing because those historical drivers are fading. That said, the consumer is taking up the baton and leading a very different growth circumstance: potentially slower, but of much higher quality. This trend is likely to bring exciting opportunities for investors as real options emerge from sectors outside of traditional banks, building materials, and real estate sectors. Sectors and companies with sustainable, differentiated advantages and real options will stand out, including those in the technology and bio-tech fields.
2. China will be fine.
Against the backdrop of domestic economic challenges and ongoing trade conflicts, China’s circumstances are largely manageable. Looking forward, any stimulus will proceed in dribs and drabs in China, but the credit taps are unlikely to be opened wide like they were in past periods of slowdown because that would run counter to the country’s need to rebalance the economy and clean up the financial sector. Instead, China might implement reforms focused on redistribution of wealth and resources within the economy, targeting the hundreds of millions of people living in urban areas who do not yet have access to adequate healthcare and education.
Even at a slower 5% pace over the long term, China will still account for 30%-40% of global GDP growth, making it the single largest growth engine in the world. However, future drivers in China are going to be quite different from those of the last 30 years. As mentioned, China has transitioned from an export-oriented growth economy to a domestic demand-driven economy. In addition, where the state-owned enterprises had been a big factor behind growth and employment historically, innovative private sector companies now lead the way.
3. Big disruptive investment opportunities are emerging in the China/EM world.
The lack of physical infrastructure development in the developing world has led to leapfrog effects with the digital world in areas like ride-hailing, e-commerce, and financial services – similar to what we witnessed in mobile telephony years ago. In the past decade or so, EM overall have become an incubator for companies focused on these incredibly powerful themes. The impact has been felt most in China, which has emerged as a hotbed of global innovation with Hangzhou, Shenzhen, and Beijing beginning to rival Silicon Valley and Boston in future industries. Consider that in 2017, China created one-third of new unicorns globally, and 7 of the top 10 in terms of valuation, including Meituan Dianping, Didi, and Ant Financial. These companies will continue to grow in importance, and many will generate outsized returns for opportunistic investors. And China boasts an enormous amount of human talent, enabling Chinese companies to develop new areas like artificial intelligence and machine learning at a faster pace than anywhere else in the world.
The bottom line is that, while China’s growth rate will slip during this transition, the quality of that growth is improving as it invests in new disruptive industries.
4. EM valuations are attractive
We believe EM valuations are broadly attractive, with the MSCI EM 12-month forward having recently fallen below its 10-year average. However, it is the opportunities in high-quality companies that matter most to us. A combination of relatively inexpensive currencies and approachable stock valuations have made us unusually optimistic. Great companies – like great pieces of art – are rarely cheap, except during moments of controversy and broader anxiety. In our view, we are in the midst of one of those unique opportunities today, given the discordant noise in global markets and geopolitics, which drove an approximate 25% USD correction in EM equities in 2018 from the January peak. We believe in embracing volatility as it grants investors opportunities to participate in great companies for the long term.
Our North Star
We maintain our approach to long-term investing in the developing world. Our focus is on idiosyncratic companies with sustainable competitive advantage, durable growth and a host of real options that will emerge over many years. In times of turbulence in markets, it is important to us to maintain our focus on this North Star.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Investments in securities of growth companies may be volatile. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investing significantly in a particular region, industry, sector or issuer may increase volatility and risk.