A dismal decade
Emerging markets have now been significant laggards for a decade. While the S&P 500 index has more than tripled over the last 10 years, emerging markets have underperformed significantly.
A dismal decade – relatively speaking – for emerging markets
Source: Refinitiv Datastream as at 31 October 2019
What should investors expect in 2020?
Challenges exist – but they may already be ‘in the price’
Undoubtedly, some developing economies will suffer should tensions over trade continue – or escalate – in 2020.
It appears that the decades-long trend towards the ever closer integration of the global economy, from which emerging markets have directly benefited, is being called into question as populism becomes a political force. The long process of globalization may now be going into reverse.
At the same time, investor positioning may already reflect this threat. Heightened risk aversion for much of the last decade has meant less capital has been allocated to perceived risky assets such as emerging markets. ‘Safe havens’ have been preferred – returns from government bonds and US equities since the global financial crisis reflect this.
Yet for stockpickers prepared to look beyond the headlines of trade wars or Trump’s latest tweet, today’s bad news might be providing tomorrow’s opportunity. The moves that Asian economies in particular have made to protect themselves from demand shocks from the West has made them more self-sufficient than in the past.
Valuations and investor positioning both suggest many geopolitical risks are already in the price. So, if growth turns out to be better than expected – or if tensions subside – emerging-market equities could suddenly represent an intriguing contrarian trade.
We can see five reasons to hope that relative returns from emerging markets could improve in the short term.
- Support from China
There have been recent signs of improving economic data, particularly from China’s manufacturing sector. There is also the potential for further policy easing from Beijing in the coming months, which would lend additional support to domestic demand and activity in the service sector.
- Easier monetary policy
Emerging markets stand to benefit from looser central bank policies. An easing in financial conditions globally should flow from the Fed’s recent interest-rate cut. With inflation generally benign, a synchronised easing of monetary policy across emerging markets would be likely to stimulate growth.
- The possibility of a deal on trade
While an escalation of the trade war between the US and China undoubtedly represents a risk in the short term, we expect to see these tensions easing ahead of US elections in 2020.
- Valuation support
Valuations also make the case for emerging markets, where stocks are trading at levels slightly below their historic average. This is not the case in some other equity markets. Emerging markets continue to offer a significant discount to developed markets.
Source: Refinitiv Datastream as at 31 October 2019
- Increasingly shareholder-friendly policies
Investors tend to regard state-owned enterprises (SOEs) as being mere instruments of local governments that pay too little regard to their minority shareholders. But there are signs of positive change here. Governments are realising that by improving corporate governance, they can unlock value in their assets. For example, the Russian government recently pushed state-controlled Gazprom to increase the dividend it pays to its shareholders.
The Chinese government, meanwhile, is pushing the country’s SOEs to lead by example by reforming their corporate governance. We believe this could unlock value and, in time, start to reduce the valuation discount on which these companies typically trade.
The longer-term case …
So, we can see good reasons to hope that returns from emerging markets relative to their developed peers could start to recover this year. At the same time, investors with slightly longer time horizons currently have a window of opportunity to buy into the long-term potential of emerging markets, which we believe remains undimmed.
The arguments for long-term allocation to emerging markets have been well rehearsed. At its most basic, emerging market companies offer investors the opportunity to buy exposure to economies where GDP growth is faster than in developed markets.
The expanding middle classes and increasing dominance of domestically focused brands should, for instance, underpin long-term returns from the best emerging market consumer stocks.
Three areas where we find opportunities today…
Russian stocks offer a dividend yield that is more than double that of other emerging markets. And a number of Russian companies – Gazprom being the highest profile among them – are moving towards adopting more shareholder-friendly practices.
There is scope for the earnings multiple on Chinese equities to move higher as capital markets are progressively opened to international investors. Mainland listed ‘A-shares’ stand to benefit as a wider pool of investors access to a market characterised by strong earnings growth and attractive valuations.
The pursuit of safe havens or mechanically buying into the market’s previous winners – momentum investing – has created an unusually large valuation gap between value and growth stocks. Value stocks are trading at unusually depressed levels. At times in the last 18 months this discount has threatened to shrink, but value stocks have not had a persistent period of outperformance – yet…
Bear in mind too that conditions faced by value stocks in emerging markets are quite different to those confronting their counterparts in developed markets. Favourable demographics, increasing urbanization and the need to invest in infrastructure mean the growth prospects for, say, a Chinese cement manufacturer look far brighter than for its European or Japanese equivalent. Similarly, the growth prospects for a Chinese bank are much more appealing than for a retail bank in the mature markets of Europe.