By Kristoffer Stensrud
“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” William Arthur Ward
Ever since the US first indicated the withdrawal of its massive liquidity programme, many global investors have shunned emerging markets (EMs). Pessimism towards major economies such as China has grown and market volatility is high. However, valuations for EMs on a price-to-book basis are getting close to their lows during the financial crisis. So, after four years of EMs underperforming developed markets (DMs) and a big divergence in valuations, we believe now is a favourable time to be invested in emerging markets, but on a highly selective basis.
In late May 2015, the International Institute for Finance reported that fund flows to EMs were likely to be at their weakest since 2009. Without steady inflows, EM countries have less money to pay debts, finance deficits and invest in infrastructure and corporate expansion. Recent outflows have been due mainly to the anticipated rate rise from the Fed and concerns about future growth prospects. Company earnings in general have disappointed expectations, meaning that investors are less inclined to tolerate other EM risks such as higher volatility, government intervention and currency depreciation.
Primarily, however, money has flowed away from EMs over the last two years and towards the US dollar and developed market assets, as the mass “carry trade” of borrowing cheaply in the West to invest in EM equities and debt for a higher total return has unwound. All these factors can have a negative effect on growth and many investors therefore allocate more of their portfolio to less volatile DMs where returns in the short term may be higher.
However, we are currently seeing significant divergence between emerging economies, stock markets and companies, creating opportunities for EM specialists to find value. India’s economy is benefiting from depressed commodity prices and is expected to continue its growth trajectory as further reforms are implemented by pro-business Prime Minister Narendra Modi. Meanwhile, in countries such as Russia and Brazil, whose economies have been hit by falling commodity prices among a number of factors, the broad market sell-off has created a number of attractive valuations.
Given this divergence, we believe certain areas will continue to attract foreign investor flows in the short term and, once the Fed has raised interest rates, more investors will start to re-evaluate the potential for individual emerging markets over the longer term.
Even with slower growth in China, EMs as a whole are likely to grow faster than DMs over the next decade and the global shift in economic power from West to East will continue. China is already the world’s second largest economy and the Shanghai and Hong Kong stock exchanges combined have one of the largest market capitalisations globally.
The IMF has said it anticipates a recovery in emerging market growth in 2016 and a long-term trend of mid single digit growth, well above the expected “new normal” for growth in developed markets.
Over the last 20 years, EM growth has been driven by mass urbanisation, economic reforms and the emergence of a new middle class with aspirations to Western living standards. Over the next 20 years, we would expect these trends to continue. According to an Ernst & Young report, the global middle class is set to expand by another three billion people by 2030, coming almost exclusively from the emerging world. Moreover, these drivers will be accompanied by other factors such as increasing intra-regional trade through organisations such as ASEAN (the Association of Southeast Asian Nations) and technological advances that should enable certain markets to leapfrog the years of gradual improvement in developed economies and go directly to more efficient, modern systems.
Despite the recent sugar rush in China, EM valuations continue to appear attractive both at an asset class and a company level, with valuations generally, measured by P/B, below 5 to 10 year averages. Once the anticipated rate hike from the Fed is passed, we could see a reassessment of emerging areas as the divergence between EM countries widens and growth prospects become less of a concern.
Kristoffer Stensrud is co-lead portfolio manager of the SKAGEN Kon-Tiki fund
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