It is certainly true that a lot of emerging markets have returned less in sterling over the past three years than the MSCI AC World Index.
But then the same is true of 75% of all country indices because the US is a large weight in global benchmarks and a recent strong performer. When we remove the capitalisation weight and take a ‘true’ average, half the countries to beat the average over the past three years have been emerging or frontier and half have been developed.
A few years ago, we were all wondering whether emerging economies and markets could decouple from a slowing and deleveraging western economy. Instead, it turns out emerging markets have decoupled from each other with local developments being more significant.
Recent performance in China has been strong: the market is beginning to realise that higher quality economic growth above 7% may be a good outcome and Chinese equities had become extraordinarily cheap.
Vice versa, markets like Indonesia are struggling with weak and weakening fundamentals having come into the summer trading at premium valuations. Less stress in the European periphery has taken the pressure off eastern and central European markets which have been doing better as a result and currency weakness in India has spurred the Indian index to new highs.
The underlying trend of faster growth in emerging markets remains largely intact but valuations are divergent. There are risks in emerging markets which we need to ensure we are getting paid to take. An important change that we need to make is to start looking at emerging markets less as a unified asset class and more as a number of different markets, each with their own distinct dynamic.
Let’s look at some examples, starting with China.
An interesting way to approach China is to compare it with another market which emerged from relative obscurity in the modern era: post-war Japan. Japanese equities started to seriously outperform the US market from around the late 1970s and continued to do so until around the end of 1989. During those 20 years, the price of the Tokyo Stock Exchange (Topix) Index increased nine times more than the S&P 500 – a significant uplift.
But Japanese GDP in this period was markedly lower than it was in the preceding 20 years. The disconnection is not difficult to explain. In the immediate post-war period, Japanese companies were investing heavily in new plant and in infrastructure, laying the foundations for a new era of industrialisation.
Growth, as recorded as GDP, was rapid but there was little excess profit, either to distribute to shareholders or to retain as capital. Neither was the success of Japanese industry evident in the 1950s and 1960s – that really only came later, from around 1970, when Toyota, Sony, Panasonic, Nissan, Canon, Shisheido and other Japanese brands started to become household names across the world.
China, in our view, could easily follow the same trajectory as Japan, suggesting that China’s current investment programme will pay dividends through the equity market over the next 20 years as it moves towards lower but higher quality growth – exactly what happened in Japan.
India is in many respects the inverse of China: great demographics, terrible infrastructure. Capital investment is too low, which risks holding back consumption in the longer run. This has led to a kind of stagflation, the worst of all worlds with an economy of weak growth and high inflation, the former weighed down and the latter fuelled by the country’s twin deficits on its current account and government budget.
The Purchasing Managers’ Index, generally a good measure of business confidence, is negative for India, indicating poor short to medium-term prospects, while the lack of capital investment makes it hard to see where or when change is likely to come. Against that backdrop, Indian companies often trade at rich valuations: western investors are trusting of democratic rule and clearly assign a significant valuation premium.
Current account imbalance is an important differentiator in emerging markets, just as it is in developed markets.
Taiwan, Russia, South Korea and China, each with a significant positive balance, are in different positions than those with deficits – including Brazil, India and South Africa – which are subject to depreciating currencies and imported inflation.
Current accounts can be managed, but natural resources and demographics are much more difficult to fix. Commodity exporters (such as Brazil and Russia) should benefit from a global recovery, while countries like India are net oil importers and will struggle to cope with a higher oil price. The result is that a stronger China might easily mean a weaker India.
That markets are demerging is not just a statistical anomaly: rather it’s a reality which is here to stay. In our view, investors make an error by considering emerging markets as a single asset class and must move towards a more granular analysis of risks and opportunities the way they already do in developed markets.
