Tread Carefully in Emerging Markets
As time goes by emerging markets are becoming a case-by-case investment proposition. Potential winners in this heterogeneous environment will be countries that retain a degree of fiscal and monetary freedom as well as a strong commitment to structural reforms. We view India and China as the best candidates to succeed in this transitional phase. Both in equity and fixed income, our focus will be on the quality and diversification of issuers.
If you’d descended into a coal mine in Britain in the early 1900s, you’d have seen that each group of miners carried a small yellow canary in a cage. While a casual visitor might have assumed these birds were merely mascots, in fact they were working animals, playing a vital role in keeping the miners safe. Canaries are highly sensitive to carbon monoxide, a poisonous but odourless gas that accumulated in mines. That meant that they would show signs of trouble before build-up of the gas became evident to the miners, giving the crews more time to escape.
In the same way that miners kept a close eye on their canaries, many investors look for signals that can tell them whether it’s safest to be in or out of the markets. And for emerging market investors, that canary, that signal, has increasingly become China. The consensus view is that the outlook for China is critical to the outlook for emerging markets in general, due to the growing influence that its $10trn economy1 exerts on the rest of the world. As a result, speculation that China is heading for a hard landing or even a financial crisis led to rising nervousness in the investment community throughout much of 2014.
Against that backdrop, we believe current expectations for China are generally too pessimistic. While the Chinese economy is facing a number of challenges as it attempts to transition to a more sustainable pace of growth, policymakers are aware of these pitfalls and have tools available to overcome them.
In our view, China has two key structural problems. The first is that growth has long been too dependent on credit-driven investment within the inefficient state-controlled sectors of the economy. Even today, with GDP growth cooling to a nominal rate of around 10%, credit is still growing at an excessive rate of around 15%2. In addition, much of this credit growth has consisted of borrowing by local governments through off-balance sheet vehicles. Many of these loans have been invested in projects we believe will never earn a high enough return to repay them and will ultimately need to be written off.
The second problem is the Chinese government’s historical focus on promoting high levels of investment in an effort to catch up with other major economies. This has resulted in the share of domestic consumption in the economy being exceptionally low by global standards: household consumption accounts for less than 40% of Chinese GDP3, compared to around 60-70% in typical developed markets. Transitioning to a new economic path that’s more dependent on consumption is vital to ensuring future growth is more balanced and sustainable.
The government is aiming to address both these issues, by limiting overall credit growth, steering credit towards the more efficient private sector and promoting domestic consumption. This is inevitably leading to a slowdown in the headline rate of growth, and it’s this shift that is alarming many investors. However, we believe, it’s important to realise that quality of growth is ultimately more important than quantity. In our view, concerns over issues such as unemployment are overdone. In the coming years a 6% GDP growth rate could generate more new employment than a 10% growth rate in 2008, due to the increased size of the economy. In fact, the structural shift should create relatively more jobs as the economy comes to rely more on the services sector rather than heavy industry, which is much less labour intensive.
Indeed, investors should take heart from the fact that policymakers are avoiding large-scale measures to boost growth. Instead, what we have seen is targeted measures intended to secure an orderly slowdown, such as efforts to ensure a gradual deflating rather than bursting of real estate bubbles in second-tier cities. At the same time, the government is accelerating service sector reforms, improving public welfare networks and continuing to deregulate the financial system. It’s also notable that while they could have devalued the renminbi in order to boost growth by further increasing exports, they kept the renminbi exchange rate relatively stable, thereby forcing companies to improve their business models and strengthen their balance sheets in order to survive. Overall, the actions of President Xi Jinping and his government suggest they are genuinely committed to far-reaching changes to China’s growth model.
Of course, there are risks as well as opportunities in this transition. But, in our view, the belief that China is heading for a crisis is largely based on misunderstandings about how the Chinese economy works. One such example is the idea that the slowdown may result in a cycle of rising defaults among corporate and local government borrowers, leading to a systemic crisis in the financial sector. We see the risks of systemic contagion as highly limited for structural reasons. China’s banking sector is state-controlled, as is around half the corporate sector. While debt levels have been rising, almost all this debt is denominated in renminbi and owed to borrowers within China. This means that resolving any bad debt issues arising from the slower GDP growth rate could be far simpler than it would be in an economy with extensive private sector or external liabilities.
Meanwhile, we believe the Central Bank has plenty of tools available to manage any resulting liquidity squeeze, such as short-term lending to banks, reserve requirement reductions and interest rate cuts. With a central government debt-to-GDP ratio of around 60%4> – modest compared to Western economies – the government also has plenty of scope for stimulus through infrastructure spending if required.
Lastly, regardless of the ups and downs of this transitional process, there are compelling fundamental reasons to be constructive about China. While demographics no longer provide the tailwind they have over the last couple of decades, they remain better than in most developed economies. The urbanisation process is also still ongoing, which should lead to rising consumption and demand for services even in the absence of overall population growth. Set against a backdrop of relatively low valuations we believe this makes a strong argument for being positive on Chinese equities over the long term.
Be Selective in Equities
Turning to the wider outlook for emerging markets, there is no doubt that many investors will have been disappointed by emerging market equity returns in recent years. This in part reflects the fact that many emerging markets have seen their competitive position worsen over that time and corporate margins have consequently deteriorated. Prior to the global financial crisis, in 2007, earnings before interest and tax (EBIT) margins were around four percentage points higher in emerging markets than in the developed world. But they have now converged to around the same level5.
While this trend has been extremely difficult in the short term, we believe in the long term it is likely to be beneficial, since it will force companies to restructure their business and move up the value chain. Importantly, while the GDP growth differential between emerging markets and developed markets has shrunk lately, it has continued to be positive. With demographics still favouring emerging markets, this differential is likely to begin expanding again in due course. At that point, the benefits of improved margins and faster underlying growth will mean the outlook for emerging market companies will once again be better than for developed market equities.
Of course, even in recent difficult conditions, it hasn’t all been doom and gloom. Some countries have performed much better than others. On the negative side, one can point to the underperformance of commodity-driven emerging markets: Brazil and South Africa are salutary examples of what happens when the transient benefits of a commodity boom are wasted.
Meanwhile, the exceptional weakness of markets such as Russia reflects a low level of trust in these economies by foreign investors, which we think means economic missteps and geopolitical concerns are likely to be severely punished. Conversely, Indian equities have performed well of late, rerating after the new government of pro-reform Prime Minister Narendra Modi came to power in May. This illustrates how investors may reward countries they believe are moving in the right direction.
This demonstrates why it’s vital for investors to seek to identify which emerging markets are well-placed and which are likely to struggle, rather than treating emerging market equity as a homogenous asset class. Two metrics that our emerging market equity team takes into account to identify potential winners and losers are fiscal capacity and the possibility of taking more debt/fiscal expansion: a composite of fiscal deficit, current account balance and external debt position. At present, China, South Korea and Taiwan score well on this while Brazil, South Africa and Turkey continue to look less appealing.
A focus on policy is also central. Many emerging markets have scope to lower interest rates over the next year or so, which should help support growth and buoy equity markets.
As well as considering domestic macroeconomic factors, it’s crucial to take into account how each economy is likely to be affected by global trends. For example, recent falls in oil prices will hinder some economies that depend on commodity exports, but benefit others that are net oil importers. Overall, unless the recent fall in oil prices is an indicator of an impending global recession, lower oil prices should be a net benefit for emerging market equities.
However, perhaps the most challenging factor is the recent trend towards currency devaluations. Over the last two years, many emerging market currencies have seen substantial devaluations of up to 30% versus the US dollar.
This response is understandable in an environment in which growth is scarce and devaluation can help to boost export competitiveness. But if competitive devaluation continues, we believe it risks putting globalisation into reverse as the victims of the process respond by putting up barriers to imports. This makes it a dangerous game for some emerging economies to play.
Overall, the outlook for emerging market equity in 2015 continues to be challenging, but there are bright spots. The emerging market team favours China on valuation grounds. India appears promising given nascent reforms, consistent monetary policy and signs that persistent economic imbalances such as the current account deficit are starting to be redressed.
Risks are Rising in Fixed Income
In contrast to emerging market equity, emerging market fixed income has performed strongly in recent years, with investors drawn to the asset class by improving fundamentals and relatively attractive yields. However, with interest rates set to begin normalising in the US in 2015, the outlook is becoming more challenging and we could see are pricing of EM fixed income.
Consequently, the time to treat EM Debt as a carry play is likely to be over and we believe the appropriate strategy for 2015 requires a more careful focus on differentiation than on yield. Investors should favour sovereign debt over corporate credit due to the faster fundamental deterioration in the corporate space. Volatility in oversold currencies has made some local currency emerging market debt more attractive than before, but with exchange rate volatility likely to persist, we think risks remain significant.
Indeed, investors are likely to have to cope with a wide variety of risks in 2015. These include familiar macroeconomic concerns, such as current account deficits in countries such as Indonesia, South Africa and Brazil, and worsening terms of trade in commodity-dependent exporters such as Peru, Chile and Colombia. Rising private leverage in countries such as Hungary, South Korea and Thailand – as well as China – may raise questions about rollover risk in private sector debt. Geopolitical risk is escalating, most notably with regard to Russia, where the medium-term outlook is increasingly worrying. In addition, there could be a risk of contagion in case of default of a country such as Venezuela or Ukraine.
However, perhaps the most underappreciated threat is liquidity. Emerging market debt has always been one of the less liquid spaces within fixed income. With underlying liquidity falling further as a result of new regulations restricting investment banks’ ability to act as market makers, we believe there are reasons to be concerned about the ability of markets to absorb a sudden reversal of the strong inflows of recent years. Consequently, our main strategy for generating alpha6 in EM debt should be shifting to a more defensive stance and paying more attention to credit quality than has been required in the recent past.
1 Source: IMF, data refers to the estimated Nominal GDP for 2014. Data as of November 30, 2014.
2 Source: CEIC, Pioneer Investments, last available data as of November 30, 2014
3 Source: CEIC, Pioneer Investments, 2013 data.
4 Source: CEIC, Pioneer Investments, last available data as of November 30, 2014
5 Source: Worldscope, FacSet, Citi Research, data available as of November 30, 2014
6 Alpha — Measures risk-adjusted performance, representing excess return relative to the return of the benchmark.