Growth differential favours emerging markets: Morgan Stanley

"The valuation discount is still there," says strategist for TD fund.

Michael Ryval 2 November, 2017 | 5:00PM

Emerging markets have seen strong double-digit returns over the past year, but strategist Jitania Kandhari argues that the asset class has merely gone through a "catch-up" phase this year. Valuations are still reasonable, says Kandhari, head of global macroeconomic research for emerging-market countries at New York-based Morgan Stanley Investment Management.

"Emerging markets have seen five and a half years of underperformance," she says. "It's only in the last year or so that EM's relative performance has bottomed, and we've seen the first significant outperformance." Kandhari works alongside Ruchir Sharma, head of emerging markets and chief global strategist, in managing the $202-million TD Emerging Markets.

"Typically, EM trades at a price-to-book and price-to-earnings discount of about 25% relative to the rest of the world," says Kandhari, an 18-year industry veteran who hails from Mumbai, India and joined Morgan Stanley in 2006. "We are around that level on a price-to-book basis, but still lower on a price-earnings basis. The valuation discount is still there on certain metrics and there is no overvaluation at this point."

Kandhari says the main driver for EM is the so-called growth differential over developed markets. "EM will always grow, on an absolute level, faster than developed markets. What matters is if that growth differential is improving. That is the key."

While some EM countries such as Russia and Brazil were in recession, Kandhari maintains that they are slowly recovering. "The growth momentum in EM relative to the developed world is clearly improving. That, historically, is correlated with relative performance of the asset class. From that perspective, the growth differential favours EM."

Looking at the larger global picture, Kandhari argues that, during the post-war period of 1950 to 2008, global growth benefited from three tailwinds: population growth, globalization and rapid increase in debt. Since the 2008 financial crisis, Kandhari maintains that we are seeing the reversal of these tailwinds, or "3 D's": depopulation as working age populations shrink, de-globalization as momentum in the flow of trade and capital slows, and deleveraging because parts of the global economy are excessively leveraged.

"We don't think global GDP growth will power ahead the way it did in the post-war era. The trend in growth going forward should be around 2.5%," says Kandhari, who has received a bachelor of commerce degree in advanced financial and management accounting and a Masters in Management Studies degree in finance, both from the University of Mumbai.

Given this perspective, Kandhari is focusing on fast-growth EM countries which are not facing headwinds. "This is the core of our macro thesis around which a large part of the portfolio and country positions are taken."

Within Eastern Europe, for instance, Kandhari likes countries such as Poland, Hungary and the Czech Republic, "which are benefiting from acceleration in growth due to external and domestic growth drivers." Within Latin America, she looks favourably on Argentina, Brazil and Peru, where reforms have been implemented and growth has shown signs of acceleration.

Within Asia, India and Indonesia are low GDP-per-capita countries with catch-up potential that are slowly seeing per capita incomes rise, due to reforms, Kandhari says. "These are the kind of countries we are backing. But we are avoiding countries like Turkey because there are structural issues such as over-leverage."

The positioning is reflected in the geographic allocations. China, for instance, recently constituted an underweight at 21% of the fund, versus 27% in the MSCI EM Index, while India had an overweight at 5% versus 2.28% in the benchmark.

One key part of the team's approach to portfolio construction is that it utilizes a proprietary country-allocation framework called the Ten Rules of the Road. These metrics range from demographics to leverage and currency stability. "The overarching themes of depopulation, de-globalization and deleveraging are woven into the country-allocation decisions," Kandhari says.

While the macro view accounts for 50% of the excess returns, the other 50% is derived from stock-picking. It's here that the Morgan Stanley team is favouring domestic-oriented consumer stocks which fit within themes such as an aging population seeking better health care and demand for higher-quality tourism. They also like financial-services stocks in countries that have low penetration rates for savings and borrowing products, and no credit excesses.

Take, for instance, OTP Bank, the largest bank in Hungary and one of the top holdings in a fund with 110 names. "Hungary has been deleveraging for the last seven years," Kandhari says. "Private-sector loans to GDP, the metric we look at for penetration, has halved. But it's now reversing as growth and confidence recover."

Another favourite name is Marico Ltd., India's largest producer of hair oil. "We like the management, and execution and corporate governance. And it doubles its earnings every four years," says Kandhari. "It is benefiting from the shift in consumer preferences from unbranded products to aspirational brands. The overall branded market is about 65% today and is expected to grow to 80% in the next decade or so."

The Morgan Stanley team seeks to add alpha by first getting the top-down analysis right and then focusing on stock selection, says Kandhari. "Based on countries' GDP per capita, we are constantly evaluating countries where growth is bottoming and accelerating."

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Michael Ryval

Michael Ryval