The tailwinds supporting emerging markets (EM) through the early part of the year gave way to headwinds and headlines of trade disputes, spiralling currencies and declining growth rates over the summer. In his latest note, Gary Greenberg, Head of Emerging Markets at Hermes Investment Management, explores the macro fundamentals underpinning the EM business environment, which remain more robust than the recent volatility might suggest.
Turkey, Argentina and South Africa have captured the market’s attention and while the travails of the three nations are real, they are partially self-inflicted and can eventually be resolved.
Turkey has been running an overly loose monetary policy for several years, and the economy has become more vulnerable as the nation’s import bill has risen with oil prices, exacerbated further by US sanctions. The Turkish authorities’ unique and mistaken view that high interest rates cause inflation has exposed the lira’s weakness. In September, Turkey’s correct decision to lift interest rates significantly higher triggered a tailspin in its economy, but with Turkey accounting for 0.51% of the MSCI Emerging Markets Index, few EM equity portfolios will have been directly impacted.
Argentina’s failure to control inflation, combined with the strengthening dollar, has resulted in an extremely weak peso – which, as in Turkey, has further stoked inflation and currency weakness. That said, Argentina is yet to join the MSCI EM Index, so it presents little direct risk of contagion for EM equities, but a weak peso doesn’t help Brazil, Chile, Colombia, Peru or Mexico, nor has it helped EM debt portfolios.
With a 6.3% weighting in the benchmark, South Africa has a greater direct impact on EM stock pickers than Turkey or Argentina. The replacement of Jacob Zuma with Cyril Ramaphosa in 2017 as leader of the governing African National Congress was welcomed by investors but with a current account deficit of 3% of GDP, no more than adequate import cover, and significant exposure to the commodity cycle, the new administration has its work cut out for it on the external front, not to mention intractable domestic challenges.
Looking beyond the troubled three, the strong tailwinds buoying EM at the beginning of the year have faltered, with local-currency depreciation, a stronger US dollar, and fears about China’s growth leaving investors with the familiar elements of EM storms.
Many of these headwinds will eventually abate however: the stimulus induced by US tax cuts should wear off next year; the dollar is near a 15-year peak and should weaken as trade and budget deficits begin to take their toll; and US policies could become less bellicose as their architect-in-chief deals with legal issues and, potentially, a Democratic majority in the House of Representatives following the mid-term elections in November. Automatic stabilisers resulting from Fed tightening are kicking in, raising the cost of short-term borrowing and tightening financial conditions generally.
Positive macro fundamentals persist through the headline volatility: we see reasonable growth, low interest rates and sensible economic policies in the majority of countries comprising the EM benchmark. EM companies are well-positioned to take advantage of this: forecast earnings per share across EMs for 2019 are stronger than those for the US and EM stocks are now trading below their long-term average1, following an earnings-based recovery from depressed levels in the past year.
Earnings estimates have dropped in EM, but the quantum of the drop is far lower in local currency. Earnings growth, like for like, in local currency, is decent this year. The consensus view extrapolates the dollar’s strength into a medium-term timeframe of three-to-five years, ignoring the short-term nature of the stimulus induced by the tax cut. As this boost fades, so will one of the main drivers of the US economy’s relative outperformance, reducing the need for rate hikes and therefore the main driver of dollar strength. As a result, the earnings of EM companies could appreciate in the terms of a weaker greenback.
Figure 10: Consensus views of earnings per share for MSCI EM stocks in local currency terms
These valuations are supported by improving margins and strong profitability, but can they persist? We think so: From a bottom up perspective, free cash flow yield is improving across many EM companies, in part because valuations are depressed but also because companies are generating more of it. Management teams have learned the value of capital discipline, sticking to their core business strengths and, in many cases, returning excess capital to shareholders. As the long-term prospects for global growth have dimmed somewhat in the past several years, EM companies’ capital spending have also become more cautious as they prefer to sweat their assets more heavily.
To us, the highs and lows of 2018 have reaffirmed one of our key convictions: that EMs are not a destination for short-term trades but for long-term investment in high-quality, sustainable companies. Macro forces – from dollar strength to commodity cycles, political fallout or economic mismanagement – will inevitably buffet the universe, advancing or impeding stock prices. Like ourselves, the companies we invest in are able to adapt to turbulent conditions, acting with discipline and capturing long-term growth opportunities. The insights gained from these experiences are valuable, capable of contributing to the positive, compounding returns throughout cycles that we have generated since inception and continue to seek – however strong the tailwinds or headwinds become.