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Emerging markets: positive fundamentals persist after Brexit vote

Hermes Global Emerging Markets

Home / Perspectives / Emerging markets: positive fundamentals persist after Brexit vote

Gary Greenberg, Head of Hermes Emerging Markets
16 August 2016
Emerging MarketsTake Note

Are emerging markets proving to be one of the few good financial news stories following the vote for Brexit? Despite global uncertainty, emerging markets are rising and the fundamentals for a revival in performance appear to remain. So, what are the positive forces supporting emerging markets?

Recent years have been difficult for emerging markets investors. In the three-year period through May 2016, the MSCI Emerging Markets Index was down 14.72% on an annualised basis as the MSCI World Index gained 19.06%. From 1 June to mid-August, however, emerging markets have surged 12.44%. Since the start of the year there has been growing evidence that emerging markets are recovering and may even outperform the developed world.

Currencies

The strength of the US dollar is implicit in the fortunes of emerging market economies, which have significant dollar-denominated debts and whose own currencies are vulnerable to devaluation. The weakening of sterling and the euro in the wake of the Brexit vote has strengthened the dollar’s safe-haven status in the short term, but the longer term signs suggest that its value may be peaking. Subdued inflation figures and continuing global uncertainty have stymied the US Federal Reserve’s intention to increase interest rates. Despite the US jobs report for June beating expectations, few analysts predict a rate rise before the presidential election in November.

Brexit remains a threat to emerging markets performance – should there be further weakening of the pound and euro, the resulting flight to quality would naturally benefit the dollar. However, in a situation where sentiment remains cautious but does not descend into alarm, the dollar may lose traction.

The valuations of most emerging market currencies already reflect a strong US dollar and are, if anything, undervalued. Historically, any gains by emerging markets through global exports have driven the Global Emerging Market Real Effective Exchange Rate (GEM REER) higher. However, since February 2011, a 1.3% decline in export market share has seen a disproportionate 12% depreciation in the GEM REER – based on the long-run historical association, this should have delivered a more modest 6% fall.

In the first half of 2016, emerging market currencies began to recover from the turbulence caused by China’s devaluation of the renminbi and the US Federal Reserve’s rate rise. Brexit is propelling this trend further. However, a slide in the value of the renminbi remains a significant risk, and better communication with the markets from Chinese policy makers is needed to provide reassurance that any depreciation will not be sudden and extensive.

Corporate margins and profitability

Return on equity across the emerging markets universe fell from nearly 17% in 2008 to 10.5% in 2015. Poor investment and over-leveraging caused financial stress, which has taken a long time to work its way through the banking system. Meanwhile, over-zealous stimulus of state-owned enterprises (SOEs), such as Brazil’s Petrobras, has hindered more than helped in the long term.

China appears to have at least partly learned its lesson and looks likely to proceed with reforms targeting supply-side growth and an overhaul of SOEs. Latin America, meanwhile, outperformed in Q2, led by Peru, which was boosted by the confirmation of its position in the MSCI Emerging Markets Index and the election of former economist Pedro Pablo Kuczynski as president. Increasingly, the region is swinging to the political centre-right, with a renewed focus on fiscal discipline – as demonstrated by the policies of leaders Mauricio Macri in Argentina and Michel Temer in Brazil.

Commodities

The commodity sector rallied in the first half of 2016, with the 29 primary commodities traded on the US and UK exchanges rising 12.67% over the six months to the end of June. Despite this, commodities are arguably the one element of the recent underperformance of emerging markets which continues to present a problem: an underlying increase in demand, which would validate a resurgence, is conspicuous by its absence. In fact, commodity markets remain oversupplied. Certain countries, Russia and Brazil being key examples, remain over-reliant on commodity-related exports and vulnerable to continuing low prices.

Microeconomic factors

There are a number of microeconomic factors which point to a positive outlook for emerging markets. Earnings momentum is still generally negative, but getting much less so, with positive momentum already apparent in Russia, Egypt, Hungary, Brazil and Korea. On a price/ earnings-to-growth ratio basis Latin America stands out, followed by Europe, the Middle East and Africa, and India.

Earnings breadth is rising, especially in Mexico, Korea, Turkey and Brazil. Meanwhile, earnings per share are increasing relative to developed markets and distributions are also rising – a good sign for long-term investment as dividend-paying companies tend to have stronger corporate governance in place and are well-placed to withstand further volatility.

Other encouraging indicators include the improvement in the current accounts, as a percentage of GDP, of emerging markets countries. Meanwhile, growth surprises are flat as this measure for developed markets is collapsing. Return on equity is up, albeit with some way to go, especially since leverage has risen.

Valuations

Despite the potential for a turnaround in corporate profitability, the vast majority of emerging markets are trading cheaply relative to history and developed markets. Across the universe, the price/book valuations for all countries except Thailand and the Philippines are at or close to the bottom of their respective ranges for the last decade.

In countries such as China, where increasing consumption and reforms are helping to rebalance the economy, and Argentina, which aims to attract more investment and enforce fiscal discipline, stocks are cheap.

Indian summer?

India posted solid gains in Q2 on the back of a bountiful monsoon season, and is worth singling out for a particularly sunny financial forecast over the next five years after recently overtaking China as the world’s fastest-growing economy. Favourable demographics are supported by Prime Minister Narendra Modi’s economic reforms, such as the recently approved national goods and services tax, which are focused on sustainable long-term growth, while growing consumption rather than a reliance on commodity exports (India is a net importer of oil) is driving stable growth. This should help insulate the country from global volatility.

There is a strong argument that the poor macro environment has already been discounted from emerging market valuations. Perhaps counterintuitively, the effect of post-Brexit volatility on developed markets increases the appeal of emerging markets as a source of stronger returns with relatively low risks. This is particularly evident in those territories such as India and Latin America, where reform momentum bodes well for the future.

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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.
Read all articles by Gary Greenberg