Emerging Market Equities – Still A World Of Opportunity by Georgina Hellyer, Columbia Management
- Despite a disappointing last five years, the structural growth drivers that have long made emerging markets an attractive area in which to invest are as compelling as ever.
- While emerging markets may be a single asset class, they are anything but homogenous. This provides opportunity for active investors to seek out higher returns.
- There are an increasing number of world-class companies to choose from, with capable management, healthy balance sheets and strong cash flow to finance their growth projects.
Emerging market equities delivered stellar returns over much of the noughties. With the Chinese economic miracle at the forefront, we witnessed a period of strong economic growth, fast-growing domestic consumption and appreciating currencies. After the global financial crisis struck in 2008, investors began to wonder whether the EM story might even prove resilient enough to withstand the economic turmoil in which the developed world found itself embroiled.
Fast forward to 2014 and the reality has proved disappointing. Over the past five years as of September 30, the MSCI Emerging Markets Index has delivered a total return of 24% while U.S. stocks have more than doubled in value. Meanwhile, UK equities have risen by nearly 60% and even equities in troubled continental Europe have increased by 36%. Yet many of the features that underpin the attractiveness of emerging market equities remain in place:
> Potential gross domestic product (GDP) growth remains higher for emerging market economies than for their developed market counterparts.
> A rapidly-expanding middle class is eager to enjoy a higher standard of living and consume a wider range of goods and services.
> Government debt levels are low relative to countries such as the UK, U.S. and Japan and, in some emerging economies, consumer credit penetration is also low.
> The corporate sector is benefiting from a slow but steady improvement in regulation and corporate governance.
So what is the problem? First, China has seen a slowdown in the growth of the working age population and rising real wages. This, coupled with weak export demand from the developed world, has left the country unable to rely on net exports to drive growth. For several years, Chinese authorities offset this with massive infrastructure spending and by allowing loose monetary conditions to fuel a domestic property boom. Now, however, the rapid increase in local government and corporate debt has made this path unsustainable. So the authorities want to create a domestic demand-driven growth model. But the transition is complicated by the previous cycle of overinvestment which has suppressed corporate profitability and left many companies with weak balance sheets. A problem for China, yes, but also for countries whose growth was fuelled by China’s voracious appetite for their natural resources.
At the same time, emerging markets remain vulnerable to the ebb and flow of global liquidity. The Federal Reserve launched its QE program in 2008 to stimulate the U.S. economy and ward off the threat of another depression. However, QE also drove down the return investors could obtain from assets such as government bonds. Some sought more profitable opportunities elsewhere, including in emerging markets, resulting in very large inflows to fixed income and equities. However, this has left emerging markets vulnerable to the eventual tightening of monetary policy or, as the taper tantrum in the summer of last year proved, to even the discussion of such.
The end of QE has weighed heavily on countries with large current account deficits, reliant on foreign capital flows to finance them. The impact is felt not only in depreciating currencies as fixed-income investors reduce their exposure to a country’s debt, but also in the domestic economy as central banks are forced to increase domestic interest rates in order to defend their currencies, which then weighs on a country’s domestic consumption and investment. Current account deficit countries are, therefore, forced through a painful readjustment process. And for exporters of commodities who are currently facing deteriorating terms of trade, this adjustment process is even more difficult.
Still, we don’t think the prospect of attractive returns from emerging market equities has disappeared. While the process of correcting the imbalances built up over previous cycles may be painful, experiences such as the Asian Crisis of 1997/1998 have shown that it can be done. Perhaps just as importantly, the structural growth drivers that have long made emerging markets an attractive area in which to invest are as compelling as ever. Areas such as healthcare, e-commerce and modern food retail formats continue to see impressive growth rates. Moreover, the last couple of years have seen the election of leaders with strong reform mandates in countries like Mexico, India and Indonesia.
Investors should not lose faith in emerging market equities, particularly when valuations remain so attractive compared to developed markets. However, now more than ever it pays to differentiate. While EM equities may be a single asset class, they are anything but homogenous. Excitingly, this provides opportunity for active investors to seek out higher returns. The key lies in identifying companies which can benefit from government reform programs, and whose business models and underlying growth drivers position them to outperform in this challenging environment. The good news is that there are an increasing number of world-class companies to choose from, with capable management, healthy balance sheets and strong cash flow generation, allowing them to finance their growth projects without the need to take on lots of leverage. Emerging markets remain a world of opportunity.
Foreign investments subject the fund to risks, including political, economic, market, social and others within a particular country, as well as to currency instabilities and less stringent financial and accounting standards generally applicable to U.S. issuers.