Emerging-markets roundtable: Part 1

 Chuk Wong, vice-president and portfolio manager and long-time member of the global equity team at 1832 Asset Management L.P. He has a wide range of mandates including Dynamic Global Value, Dynamic Global Value Class, Dynamic Far East Value and Dynamic Emerging Markets Class.

James Upton, senior portfolio strategist and chief strategic officer for the Global Emerging Markets Team at New York-based Morgan Stanley. The firm's extensive emerging-market mandates include TD Emerging Markets.

This three-part series continues on Wednesday and concludes on Friday.

Q: In 2013, the MSCI Emerging Markets Index had a total return in Canadian dollars of 4.3% versus 35.9% for the MSCI World Index, a substantial underperformance. Emerging markets have also been under pressure since the beginning of 2014.

Strauss: It's been a challenging start to the year, but it has provided some interesting entry points. The 2013 underperformance was driven by two factors. Externally, the U.S. Federal Reserve Board's quantitative easing has been an important driver of emerging-market performance. There was a major sell-off in emerging markets last May on concerns that the Fed would start to taper. This was pivotal. Years of easy and cheap global liquidity had supported them with flows of money into these markets and little distinction being made between weaker and stronger EM economies. Talk of tapering in May, followed by the December announcement that tapering would commence in 2014, has weighed heavily on emerging-market sentiment. This was particularly noticeable in the currency and fixed-income EM markets, but the negative sentiment also spilled over into the equity market.

Matthew Strauss

Within emerging markets, there were some significant economic-growth downgrades throughout 2013, with investors adjusting their corporate-earnings expectations and GDP-growth expectations. By contrast, there were a number of factors that worked well for developed equity markets, so that you ended 2013 with this substantial difference in performance.

Upton: Over the last year, there was a big downward shift in economic growth among some of the larger countries, such as China, Brazil, Russia and India, as well as South Africa. Commodity-producing countries such as Brazil, Russia and South Africa were exporting the raw materials that China was consuming in its exceptional, double-digit-per-annum growth phase. There was also a healthy demand globally for natural resources.

Our view was that that the commodity boom was not going to last forever. Based on 150 years of data, the upward phase of the commodity cycle lasts for some 10 years, before supply catches up.

Toward the end of 2009, the expansion phase of the cycle was coming to an end. It got more life support because of quantitative easing, which extended the upward pressure on commodity prices a little longer. But, by then the big economies in emerging markets were adjusting their growth downward, based on declining demand for natural resources and declining demand from developed countries for emerging-market exports. Against this backdrop, the MSCI Emerging Markets Index has lagged the performance of the MSCI All Country World Index since mid-2011.

Q: Chuk, why this underperformance?

Wong: As a portfolio manager, I am looking to buy stocks of companies that can maintain or grow the return on their investments, over time. In the last few years, there has been a decline in the emerging-market corporations' returns on investments. It makes these EM corporations less attractive than their counterparts in developed countries. Europe, the United States and Japan have been recovering and individual companies in these countries have been able to generate better returns on their investments.

Chuk Wong

The underperformance of the benchmark MSCI Emerging Markets Index reflects, in large part, its exposure to commodities and its 27% weighting in financial services. The latter has been affected by the downward revision of EM growth. Until a few years ago, investors looked at the emerging markets as a proxy for commodities. The index is still very commodity-driven, but the key driver in the last few years has been demand from China rather than from the developed economies. Now that there is a little uncertainty about the outlook for China's growth, the commodity-driven sectors and economies are not doing as well. Also, a number of emerging countries have been faced with political challenges. This also increases uncertainty and stock markets do not like uncertainty.

Strauss: There are a lot of political problems, for example, in the Middle East and more recently the Ukraine. An underlying issue is how emerging-market governments handle their peoples' aspirations. The high EM economic growth rates created a spirit of optimism and there was less focus on the political system. Now, we have entered a period in which emerging-market growth rates are slower than they were in the last decade. People are concerned that their aspirations will not be met. This creates frustration, which turns into a social or a political problem. We've gone through a period of exceptional economic growth and surprisingly good political stability. This is an aberration rather than the norm for EM. Our approach to investing in these markets is to be even more selective.

Upton: Politics do and will matter. We have observed that older regimes tend to be the ones whose ideas stagnate. The high-profile protests last year tended to be in countries like Brazil, Turkey and Russia. These are countries where the regimes were running out of fresh ideas. In countries like India, the elections this year could potentially bring about some reform. Also, the reform-minded government in the Philippines has created a virtuous cycle.

Strauss: The Philippines is an interesting area. Our preference is for those countries that have both the willingness and the ability to implement reforms. India is a country where the politics will dominate in 2014.

Q: What has happened to the GDP growth rates in emerging economies?

James Upton

Upton: If you strip out China's GDP growth rate, several of the larger EM economies, such as Brazil, are growing at less than the rate of the United States. EM used to grow at three times the rate of the GDP growth in developed countries. Investors were attracted to this. That growth differential has diminished to two-to-one currently. One key factor overhanging emerging markets is China. China's growth, in our opinion, could disappoint consensus expectations.

Strauss: It was an easier time to make money in emerging markets in the boom period, when even the weaker emerging markets were growing strongly. Over the last two years, we have seen this sharp decline in the growth-rate differential between emerging and developed markets from three-to-one to two-to-one. I am somewhat optimistic. I think that the narrowing of that gap is getting closer to a bottom.

Q: Relative valuations of developed versus emerging stock markets?

Upton: The MSCI Emerging Markets Index is currently trading at a 30% discount to the MSCI All Countries World Index based on trailing price-earnings ratios. The discount went as high as 45% in 2000-2001 and reached 46% by the end of 2001.

Strauss: A lot of the negative news is already priced into the current valuations of emerging-market stocks. China remains a problem. If its growth slows down quickly, this could negatively impact investor sentiment towards emerging markets. This is one of the big risks.

Wong: The emerging markets do face some challenges near-term. But, over the last decade, these economies have evolved into more market-driven and more open economies. Also when investor sentiment is so negative about emerging markets, it's the time to start looking. Valuations are cheap. The secular fundamentals for emerging economies are still intact. They are the favourable demographics, the high savings rates and the emergence of a number of globally competitive companies. This is the case for investing in emerging markets longer-term. But investors have to be more selective.

Upton: Emerging-market equity returns are likely to pick up relative to their underperformance of the past three years. Our call is that EM equity returns are likely to be in the high-single-digits range on average over the next three years, with the added benefit of higher-return prospects from frontier countries [pre-emerging markets].

Wong: The frontier markets are interesting. They are underfollowed and underappreciated and are less vulnerable to foreign capital flows. I have some exposure to these markets in Dynamic Emerging Markets Class.