The inside-out story of emerging markets

Chinese leverage, currency fluctuations, and other evolving risks, but still promising opportunities in select regions

Morningstar 10 June, 2019 | 1:47AM
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The late Sir John Templeton was famed for saying “the four most dangerous words in finance are ‘this time it’s different’”. This wisdom has provided a lot of value over the years and his preference for historical analysis has been particularly useful in understanding market cycles in a long-term setting. However, one must also be mindful that markets evolve. Emerging markets are a great way of illustrating such dangers as history is unlikely to repeat itself in this heterogeneous and progressive block.

The fact that almost 80% of the emerging market index is from countries that weren’t even investable in 1988 demonstrates how far emerging markets have come. Countries such as China, Russia and Taiwan have opened up and taken a large amount of market share relative to the 1988 exposure which was dominated by Malaysia.

The same issue also applies by industry, with drastic changes notable. Information technology is better known for its U.S. representation, but has been a big mover in emerging markets too and now accounts for around 24% of the emerging market index (and around 33% in Asian emerging markets). This has evolved from just 5.5% of the emerging market index in the late 1990s. 

Technology in emerging markets has been on a tear


Therefore, while a lot of hype surrounds the recent divide between developed markets and emerging markets, care needs to be taken in drawing comparisons. It is certainly true that developed market equities have outperformed emerging markets over 1, 3, 5 and even 10 years, although this hides many of the interesting stories—and opportunities—beneath the covers.

To be clear, we continue to like parts of emerging markets—both stocks and bonds. It’s important to remember that emerging markets are comprised of different regions; including Asia, Africa, Eastern Europe and Latin America. Consequently, the economic and fundamental drivers of performance can be quite diverse. This applies whether we’re looking at stocks (company dynamics) or bonds (including government debt). Because emerging markets are not homogeneous, they represent fertile ground for valuation-driven investors to pick investments that can add value over the long-term, while avoiding those assets with poor reward for risk.

Reflecting this, our order of preference within the emerging market equities gamut is EM Europe, then EM Asia, with EM Latin America our least favourite. We also include some of the developed markets for comparative purposes, which helps illuminate the opportunity set.

Our expected long-term equity returns by region, using a “valuation-implied return” framework


As advocates of valuation-driven investing, we must also consider emerging markets on a risk-adjusted basis. This requires one to think carefully about the expected returns—comprising the payouts (yield and buybacks), underlying cashflow growth and any valuation change over time—as well as any fundamental risks that could meaningful cause a drawdown.

Under this lens, perhaps it is easiest to address the key fundamental risks first. We know that since the 2008 financial crisis, Chinese banks have grown their assets significantly by lending to local governments and households. This impacts emerging market financials, where the largest country exposure is unsurprisingly China, accounting for 29% of the index, with the next 42% spread reasonably evenly between India, Brazil, Taiwan, South Africa and South Korea. Therefore, while emerging market financials are certainly not isolated to the China story, they are heavily influenced by it.

As long-term investors, we are not in the business of predicting if or when a Chinese debt crisis may flare, however we do know that as the government looks to tighten liquidity, banks face the prospect of holding more capital while potentially incurring higher bad-debt provisions. When considered holistically and over the long term, one should expect a negative impact on profits over time with flow on effects to return-on-equity, requiring a margin of safety to be built into EM financials valuation metrics (we specifically factor in a “fair” return-on-equity closer to 9.5% rather than the circa 12.0% achieved over the past 20 years).

Looked at this way, we agree with the consensus and don’t see much attraction in the emerging market financials sector given current pricing and the potential downside risk. However, we don’t agree that the full-blooded contagion fears are justified, as many regions and sectors still look fundamentally healthy and are expected to deliver positive outcomes.

The devil in the detail: currency volatility

Another key risk is currency, especially given most emerging market products are only offered in unhedged terms. For example, while the emerging-markets benchmark slipped 4.5% in local currency terms in 2018 through to September 2018, it sank 10.2% for relative to the U.S. dollar. This highlights the fact that much of the underperformance was driven by emerging-markets currencies losing ground to the U.S. dollar, rather than the performance of the underlying basket of companies.

Much of emerging markets’ 2018 slide was caused by currency declines


Interestingly, much of the currency depreciation has been isolated to emerging Europe, the Middle East, Africa (especially Turkey, Russian, and South Africa) and Latin America (Brazil and Chile). To put a finer point on it, investors appear to be pessimistic about the entire market because of a few troubled emerging markets. Turkey has perhaps made the largest media headlines, however Turkey's impact on the market is insignificant compared with that of China and, to a lesser extent, countries like South Korea, South Africa, and Brazil. In short, emerging markets are heterogeneous and the impact of currency matters.

Emerging markets: worthy or not?

When combined into a broader conviction, we find that the attractiveness of emerging markets as a whole is somewhat waning in absolute terms, but still valid in relative terms. The case for emerging markets strengthens when we are selective about which regions to invest in.

Here, we find EM Europe and Asia the better valued regions, with country-specific opportunities appearing in Korea and Russia in particular. As with any market that exhibits unusual risks, sizing is important—where one must understand the role any exposure is playing and its relationship to other assets. Emerging markets may not be for the faint hearted, but if used correctly they can help an investor achieve healthy risk-adjusted rewards over the long term.


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