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Emerging markets: through the looking glass


Home / Perspectives / Emerging markets: through the looking glass

Gary Greenberg, Head of Hermes Emerging Markets
29 September 2016
Emerging Markets

Key points

Are we tripping through the looking glass? Rising protectionism in the West, entrenched authoritarianism in the emerging world and distortions caused by unconventional monetary policies challenge the underpinnings of financial markets in recent decades

The US presidential race typifies the protectionist surge in developed markets. We explain why the election of Donald Trump would undermine the progress and global influence of the US and destabilise the global economy, with severe consequences for emerging markets

Unconventional monetary policies, introduced as emergency measures, are now causing the economic stagnation they were meant to cure. This is having a profound impact on the financial health of Westerners, and therefore the emerging world

Emerging markets have staged a stunning turnaround this year. We ask whether recent political developments and economic and corporate fundamentals – which have been improving throughout the year – can sustain the recent gains over developed markets

As we go through the looking glass into a world of negative interest rates and fact-light pitches from US presidential candidates, many investors are likely starting to feel like the doomed oysters in “The Walrus and the Carpenter”. In this issue of Gemologist, we assess several developments – all of which shake the frameworks through which we are used to viewing economies and policies – that will influence emerging markets in the next year.

The time has come,’ the Walrus said,
      To talk of many things:
Of shoes — and ships — and sealing-wax —
      Of cabbages — and kings —
And why the sea is boiling hot —
      And whether pigs have wings.

– From “The Carpenter and the Walrus,”
by Lewis Carroll, published in 18711

Of shoes – and ships – and

The rise of protectionism in the West

Global trade has increased enormously over the last 30 years, as the invisible hand, in its wisdom, redistributed wellbeing and manufacturing capacity from the workers of the developed world to those of emerging markets. This has resulted in a shrinking middle class in the developed world, weakening demand and slowing growth in world trade. This in turn has affected emerging market businesses geared towards exports, such as Chinese ports.

The upcoming US election could have significant consequences for world trade and therefore emerging markets. Democratic nominee Hillary Clinton is, at the time of publication, just ahead in polls of the popular vote, but is further ahead in the Electoral College, where voter-appointed electors from each state formally decide on who will be the president and vice president. Nevertheless, polls have recently been poor predictors of election results, and any combination of a change in tactics by her opponent, the emergence of a new scandal and a bad performance in televised debates could swing voters to the Republican Party’s Donald Trump.

There is a reasonable chance that a Clinton victory would be accompanied by Democratic supremacy in the Senate, though the Republicans seem assured of keeping control of the House of Representatives. A Trump victory would likely result in the Republicans maintaining their hold over both houses.

Both candidates seem likely to propose fiscal stimulus targeting infrastructure. Clinton would pay for this through higher taxes and a pension-fund-supported infrastructure ‘bank’, and Trump through a dedicated infrastructure fund backed by government bonds. Both would likely grant a tax break to domestic corporations in order to reel in cash from US businesses operating overseas, though the predictable success of lobbying efforts would ensure that this repatriation is unlikely to result in much tax revenue.

Clinton represents business as usual on trade, notwithstanding her grandstanding on the North American Free Trade Agreement (NAFTA) to appear tough on trade policy, and proposing changes to pending agreements such as the Trans-Pacific Partnership. This makes the key issue for emerging markets – and indeed markets in general – the impact that a Trump presidency would have on world trade.

China and Mexico enjoy large trade surpluses with the US, representing just over 1.5% and 0.6% of US GDP respectively. If elected, Trump could restrict imports, as threatened, primarily targeting these two countries. The US Treasury could brand China a currency manipulator, potentially leading to countervailing duties on Chinese imports, which generate just over 2% of China’s GDP. Trump could exit NAFTA, possibly even without congressional approval, compromising exports that account for about 9% of Mexico’s GDP. Building a wall might help Cemex, but this would be cold comfort in a very uncomfortable situation.

If Trump decides not to target individual countries, he could aim to make good on his threat to leave the World Trade Organisation (WTO), although this is likely to require congressional approval. Other emerging markets whose exports depend significantly on US demand include Thailand, Korea and Malaysia. A further economic blow to emerging markets would result from Trump’s aim to block or even appropriate remittances, particularly to The Philippines, where they finance 3.5% of GDP, and to Mexico, where they account for just under 2%.

Geopolitically, a Trump-led withdrawal from foreign engagements could encourage more aggressive activity by America’s traditional rivals, China and Russia. For global trade and stability, the great concern of an isolationist, America-first Trump presidency is the reversal of US foreign-policy commitments made in the last 70 years, which focused on keeping the sea lanes open and secure for all, preserving European peace and protecting Arab oil exporters.

A perceived power vacuum, resulting from the US’s refusal to protect countries that are not themselves contributing significantly to regional security, might spur further military action in the South China Sea, more missile launches by North Korea, and Russian challenges to the North Atlantic Treaty Organisation (NATO). On the other hand, a weakened European Union (EU) following Brexit, along with a US president less committed to NATO, could lead to relaxed sanctions that support a recovery of the Russian economy.

With the US exerting less global influence, any improvement in Russia’s geopolitical position may be partially offset by Trump’s domestic energy policy. He would likely focus on maximising domestic oil and gas production by abolishing regulations that increase drilling costs, and accelerating exploration and development on federal lands and offshore areas, which has been prohibited under the Obama administration. More US production would mean lower energy prices globally, which would harm the economies of the Middle East, Russia, and Mexico, but would benefit the majority of emerging markets, which are mainly oil importers.

If the US entered a trade war with China, perhaps sparked by increasing military tensions, it would lead to significant losses for both economies. Unemployment in China could rise to levels that threaten social stability, and in response the authorities could then impose capital controls, change the composition of its foreign-exchange reserves to include fewer US Treasuries, and restrict US firms’ access to its market. China’s central bank has enough firepower to manage the 

pressure caused by a protectionist US, but the rest of Asia would find it difficult to adjust to lower trade surpluses and possibly weaker security.
A US-China trade war would likely have global consequences, driving Asian exporters into steep downturns and potentially causing a worldwide recession.

Global markets would not celebrate a Trump victory. Bond prices would likely tumble due to his willingness to countenance a budget deficit of 10% of GDP, and stocks would follow suit as investors discount the threats of new tariffs, an exit from the WTO and a trade war with China. The deficit and trade war could lead to higher interest rates and a stronger dollar, neither of which are associated with strong emerging-market stock markets or currencies. If yields on US Treasuries rise, those on emerging-market sovereign debt would also climb higher. 

Trump’s bombastic politics may be ugly, but the economic consequences of him governing the world’s largest economy would be worse.

Of cabbages and kings

Authoritarianism takes hold

The secular slowdown in global growth has contributed to the rise of populist figures such as Trump, Marine Le Pen in France, Frauke Petry in Germany and Nigel Farage in the UK – though none has reached office, and the latter hit the exit after Brexit.

In emerging markets, however, the picture is considerably darker. The new new thing is authoritarian governments, which now hold power in more than one-third of the emerging-markets benchmark, namely China, Russia, Egypt, Poland, Hungary, Turkey, Malaysia and Thailand (and to some extent South Africa).

An archetypal authoritarian regime is driven by an ideology that claims supremacy above all others: Mao Zedong removed all political dissenters (and China’s current president, Xi Jinping, carries on the tradition) and the Kim dynasty in North Korea has ruthlessly eliminated any challenge to its maxim of juche, or self-reliance. They are nothing new. The pharaohs, not to mention Roman emperors, executed subjects who failed to recognise their divinity. The rulers of ancient Athens executed Socrates for encouraging citizens to question their leadership. The obvious losses to a society from such repression are progressive ideas – be they political, economic, technological, scientific, entrepreneurial or cultural. Under Mao’s rule, scientific hypotheses were carefully screened to ensure they did not implicitly or inadvertently conflict with the state’s ideology.

Free debate can help a political system evolve, whereas suffocating it creates an echo chamber in which only one view is reinforced. At best, conflicting ideas are dismissed as wrong; at worst, they are judged heretical and bring retribution. The tendency for authoritarian rulers to wall off their economies from foreign investment (and therefore ideas and influence) typically incurs detrimental economic consequences. Most North Koreans are impoverished, Indonesians suffered under Sukarno’s economic nationalism, and tens of millions starved during Mao’s attempt to make China self-sufficient. Things started to improve for the Chinese when Deng Xiaoping began to liberalise the economy.

Therefore one of the most important aspects of an authoritarian regime with regard to investing is not whether it is a democracy or dictatorship, but whether the economy is open or closed. China’s adoption of capitalism shows that authoritarian governments are typically hostile to our shared values of political representation and respect for human rights but are not always economic failures. Singapore developed quickly under Lee Kuan Yew’s authoritarian rule, as did South Korea under Park Chung-hee, and Taiwan under Chiang Kai-shek. But such progress was dependent on the pragmatism of these leaders and their intelligent decisions to open economies to outside investment, knowledge, technology and ideas.

Closed systems often fail to thrive. For example, Mussolini’s pursuit of autarky, sold to the public as a hybrid of capitalism and communism, saw the Italian economy grow from 1923 to 1939 at half the rate set in the previous liberal period. By 1933, more than 2m people were unemployed out of a total population of 42m, implying an estimated unemployment rate of 16%, adjusted for agricultural workers. Millions more were under-employed. Despite the state’s focus on self-sufficiency, more than 30% of jobs in agriculture were lost and many women were forced to surrender their jobs to unemployed men. But there was a modest achievement: industrial production rose by 9%, overtaking agriculture as the largest contributor to Italy’s gross national product for the first time, and for a few years the trains famously ran on time (although this didn’t last long). State expenditure on conflicts from 1935 onwards meant there were no reserves available for the war ahead.

The current authoritarian governments in emerging markets are typified by one-party ‘democracies’, the repression of civil liberties and remote prospects of peaceful changes in government. This presents increasing risks and challenges for minority investors. Ethical investment models generally exclude Sudan and Myanmar, but it is unclear if, after Aung San Suu Kyi’s 2015 election victory, the latter is a worse place to invest than Thailand or Russia. Without guarantees that minority shareholder rights in these countries will be respected, is engagement with companies on strategic and environmental, social and governance risks a viable hope or a pipe dream? And if citizens’ rights are not preserved, how secure are property rights, ultimately? An illegitimate government, by definition, stands on a shaky foundation: not only because it could change the rules without warning, but also because its lack of a popular mandate makes any real change in leadership likely to be violent and result in chaos.

And why the sea is boiling hot…

Economies are running cool on hyper-liquidity

Why is the vast increase in liquidity from years of quantitative easing (QE) not working? If interest rates determine the price of money and are now negative in the developed world, logic dictates that money is becoming worthless.

In 1922, Rudolf Havenstein, President of the German Reichsbank, was facing a disaster. The nation was heavily indebted after funding World War I through borrowing, a situation exacerbated by the hefty reparations demanded by the winning side. This had prompted the value of the German mark to halve during the war and halve again in 1919, which, coupled with the insufficient tax revenues, left the country on the verge of bankruptcy. Havenstein thought the solution was simple: as it was widely assumed at the time that the money supply and the rate of inflation were not linked, the Reichsbank should just print more money. But this accelerated the devaluation of the mark. Undeterred, Havenstein demanded that more factories be built to print money, and by 1923 the value of one gold mark was equal to 1tn paper marks. The British ambassador at the time, Lord D’Abernon, wrote: “In the whole course of history, no dog has ever run after its own tail with the speed of the Reichsbank.”2 The circles only stopped when a new currency was introduced.

Figure 1. An inflationary blitz in Germany after WWI


Source: Reinhart and Rogoff, Guggenheim Investments as at September 2016.
Note: Inflation for the above countries is the respective consumer price indices normalised at 1919 levels.

Nearly a century later, central bankers in Japan, the US and Europe are printing money to the opposite effect but may be struck by a similar sense of confusion. As they buy more bonds, interest rates sink further as less supply in the face of constant demand increases prices, pushing yields into negative territory. Central bankers give implied commitments to provide ‘puts’ to do ‘whatever it takes’ to support markets – going so far, in one region, as to purchase debt from favoured private-sector counterparties. Globally, there is more than $13tn in negative-yielding debt, equivalent to nearly 75% of US GDP.

If bond returns were being eroded by high interest rates, QE would be working, spurring businesses to invest and create jobs. Any harmful side-effects might have been be palatable. Unfortunately, QE’s benefits – keeping liquidity flowing and boosting asset prices – passed the point of diminishing returns some time ago and are now becoming detrimental. We are in a period of structural economic stagnation, with interest rates well below their long-term natural levels, leading to the misallocation of capital. Uneconomic companies, particularly state-owned enterprises, and countries have been able to borrow despite the correspondingly poor real returns they offer. Regular readers of Gemologist will be familiar with the ICOR, the incremental capital output ratio, which measures the marginal amount of investment capital necessary to generate the next unit of production. In China, this metric has increased from 4x to 6x-8x times since the 1990s, meaning it takes a lot more capital to generate each unit of growth. China isn’t alone in this: many Western countries also exhibit a higher cost of growth. So in spite of technological advances, productivity growth is in short supply.

Policymakers bemoan the savings glut, but their repression of interest rates has become part of the problem. Pension funds’ liabilities rise in value as their discount rates fall, and as discount rates trend towards zero, liabilities become infinite. Of course, when long-term interest rates turn negative, pension funds will seemingly no longer have a problem – presumably, pensioners may be due less and less each year.

In the developed world, insurers and banks are also struggling to earn a return and low interest rates have prompted some UK lenders to begin charging customers to hold their money. Without the prospect of a positive yield curve, the outlook for credit growth is modest at best. And without profits, financial intermediaries will go out of business and money-market funds will struggle, concentrating risk in the commercial paper of weakening banks.

Finally, as ageing populations still need to invest for retirement, the need to build precautionary savings intensifies as rates head towards zero. It’s no surprise that spending in the developed world is muted, despite the recovery in US employment. As health care and education costs spiral, the ability to meet these liabilities weakens further. People save more, not because they would like to buy the latest Samsung TV, but because their financial future is at severe risk. This has obvious implications for emerging markets: weaker consumption in the West means fewer imports from factories in China, Taiwan, India and other exporters.

In theory, the solution is simple: begin to sell-down central banks’ bloated balance sheets, while signalling that the era of super-low interest rates is coming to an end, as Janet Yellen did at Jackson Hole recently. Then, politics permitting, start raising rates to perhaps 1.5% in real terms across major developed markets. Returning through the looking glass into a normalised economic environment would be salutary and encourage corporations to invest. This would potentially deliver many benefits: central banks would gain the ability to ease when the next crisis hits, the financial system would operate with a rate structure through which it can remain profitable, savers would have more disposable income to spend, and the cost of capital would be lifted to a level that prevents projects with negligible expected returns from being financed. Of course, banks, insurers and pension funds will take a severe accounting hit from rising rates, and may require a temporary backstop from central banks, but after a few years the problem should be solved.

Many Fed Governors are confident that tightening can begin (see figure 2). Ourselves and others are still waiting for them make the first move.

Figure 2. Parallel universes: Fed Governors’ views of future US interest rates compared with the market’s


Source: Federal Reserve as at 15 June 2016.

And whether pigs have wings

Can emerging markets keep flying?

The MSCI Emerging Markets Index definitively bottomed on February 12 2016, and surged beyond 26% by 31 August to beat the MSCI World Index by more than 10%. The turning point coincided with the end of Janet Yellen’s testimony to Congress in February, in which she discussed the depreciation of the renmimbi and weak commodity prices. The market took this as an incentive for risk-on trades, and large yield-seeking flows into emerging-market portfolios ensued.

The carry trade was on. With the Fed refraining from raising US rates, the dollar would weaken, making the larger nominal yields available in Brazil, Russia, and South Africa relatively risk free. The Brazilian real duly gained 22% until reversing on 10 August, while the rand and rouble both appreciated 17%. Large capital flows into these countries boosted their currencies, of course, but also buoyed their stock markets, where shares of highly indebted companies that stood to benefit from lower domestic interest rates rose substantially.

Other supportive forces were at play, too. China’s 2015 stimulus led to a recovery in the housing market, and government spending on infrastructure drove a widespread rally in commodities and commodity-related companies from China to Brazil. The Brazilian Government’s decision to impeach President Dilma Rousseff gave investors fresh hope that sensible economic policies would return to spark a sustainable economic recovery. In Korea, share buybacks by Samsung Electronics led investors to bet on a sea change in corporate governance and capital discipline in the market. And a rising oil price, assisted by a weaker dollar, led investors to cover shorts and renew bets on Russia’s economy.

During this rally, the price-to-book value estimate for emerging markets in 2016 jumped from 1.25x, which we saw as attractive, to 1.4x, which we perceive as neutral. Of course, an upward adjustment in valuation would make sense if emerging markets were coming out of a trough. However, the outlook for earnings this year and next has deteriorated, dropping by about 5%. This was mirrored by a decline in estimated profitability: at the beginning of the year, consensus estimates on the return on equity (RoE) for the MSCI Emerging Markets Index in 2016 were at 9.9%. By the end of August, it stood at 8.5%. The outlook also deteriorated: consensus RoE for 2017 was 11.4% at the beginning of the year and 9.3% by the end of August. So yes, pigs can grow wings, though how long they can fly requires scrutiny. After a correction, however, especially in the higher risk emerging markets, there is a good chance that emerging markets can resume their flight path.

Compared to developed markets, the outlook for economic growth is positive for the first time since 2010 and is likely to persist (see figure 3).The contraction in Latin America has continued to ease as Brazil’s worst recession since the 1930s abates; economic activity in China, India, Indonesia and Korea is increasing as well.

Figure 3. Emerging markets outperform when they outgrow developed markets


Sources: MSCI, Oxford Economics. International Monetary Fund, Credit Suisse as at September 2016.

Economic reform in China, Russia, Turkey and Indonesia has recently been conspicuous by its absence, but India Prime Minister Narendra Modi has been successful in passing a national goods and services tax. Moves such as these, along with the swing from the political left to the centre in Brazil, Peru and Argentina should support market sentiment in those countries.

Earlier this year, we pointed to rising productivity and declining wage growth in emerging markets, and are pleased to see that this trend is continuing. Moreover, it is far more pronounced than in developed markets (see figure 4). Profitability remains depressed but should improve as global supplies of materials and energy are rationalised and demand in Asia and the US continues to increase.

Figure 4. Productivity v real wages in emerging and developed markets, 2005 to present


Sources: Thomson Reuters, Credit Suisse as at September 2016.
Note: the EM7 nations are China, Brazil, Russia, India, Mexico, Korea and Turkey.

Such optimism is amply factored in to current stock valuations, so a correction would provide a good entry point to attractive companies. Even though emerging markets are subject to a number of political risks from within and without – including rising protectionism in the West, the oppressive nature of authoritarian leaders, demand-sapping QE and carry traders looking for a fast buck – there is evidence that economic and corporate fundamentals are improving and should support a steady recovery in earnings over the next several years. We’ll pay attention to these indicators as we search for opportunities, staying on the right side of the looking glass.


The Walrus and the Carpenter - Lewis Carroll

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Gary Greenberg Head of Hermes Emerging Markets Gary Greenberg joined Hermes in September 2010 in the Emerging Markets team. Previous to this, he was Managing Partner at Silkstone Capital and Muse Capital, both London-based hedge funds he co-founded and managed in 2007 and 2002, respectively. From 1999 through 2002 he was Executive Director at Goldman Sachs in New York and London, where he co-headed the Emerging Markets product for GSAM, and served on the global asset allocation and European stock selection committees. From 1998 to 1999 he was Managing Director at Van Eck Global in Hong Kong and New York, where he was the lead portfolio manager for International Equities and ran the Hong Kong Office. From 1994 through 1998 Gary was Chief Investment Officer at Peregrine Asset Management in Hong Kong, managing and supervising global and regional equity, plus fixed income funds. In the early years of his career he was a Principal of Wanger Asset Management in Chicago, where he co-founded and co-managed the Acorn International Fund, which grew to $1.4 billion under his tenure. Gary holds an MBA from Thunderbird School, a BA from Carleton College and is a CFA charterholder. In 2017 Hermes Global Emerging Markets was named best emerging markets fund for the second year in a row at the Fund Manager of the Year Awards and best emerging markets group by Citywire Deutschland, and Gary was named best manager for emerging markets equity by Citywire UK.
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