Roundtable: When emerging markets turn, they turn quickly

Emerging markets have underlying strengths and each country is developing in ways that investors are possibly unaware of. Our panel of specialists discusses risks and capital allocation, from Latin America to Asia.

Darek Kedziora (portfolio manager, EM Opportunities, Aviva Investors)
Rishi Patel (lead portfolio manager, global emerging markets and Indian equity, LGM Investments)
Nick Robinson (investment director, global emerging market equities, Aberdeen Standard)
Ewan Thompson (fund manager, Liontrust Emerging Markets Fund, Liontrust)

Funds Europe – Which emerging market regions, countries or asset classes are currently of most interest?

Ewan Thompson, Liontrust – In terms of equities, there are plenty of countries and sectors to choose from. The biggest overweight we’ve been running all year is Russia. Over the last couple of years, we’ve seen correlations with EM drop quite a lot, so it’s now trading in quite an idiosyncratic way.

One major concern has been countries with high debt and exposure to external financing requirements. Russia has very low sovereign debt and a budget surplus – it’s one of the more resilient countries from a macro perspective. Obviously, there’s a very specific sanctions risk, but again uncorrelated to the rest of EM. So, the first thing would be that Russia is behaving quite differently, it’s one of the highest-yielding markets out there, if not the highest, with about 7% yield, and a lot of the companies have really significant cashflows.

Nick Robinson, Aberdeen Standard – Brazil is one of our favourite markets. There’s quite a lot of positive things going on there: we’ve got quite a strong political tailwind, in terms of a centre-right government that seems to have a reasonable amount of support within congress. They’ve managed to pass their pensions reforms, which were critical for getting Brazil back on to a path of fiscal responsibility. Given the momentum that they’re seeing with those reforms, I can see tax reforms, telecom reforms and energy reforms coming through, particularly if [president Jair] Bolsonaro gets another term.

Inflation has fallen significantly and seems to be under control, which has allowed the central bank to lower rates to 5% today. It has been falling pretty fast and the low level today is completely unheard of in a Brazilian context, since the creation of the real. I think that’s significant because Brazilian pension funds, which are the major investors in the Brazilian markets, are almost entirely allocated towards fixed income at the moment. As these higher-yielding instruments that they’re invested in expire, they will have to look elsewhere to generate income. That asset allocation shift and increased local ownership of Brazilian equities is likely to be something that drives the market in the coming months and years.

Rishi Patel, LGM Investments – My comments are restricted to equities. China and India continue to be the juggernauts of the space. While they have many differences, combined they account for about 11,000 listed companies (out of a total of around 25,000 across the developing world). They should be big happy hunting grounds for long-term equity investors. Other markets (Mexico and Vietnam) are expanding their capital markets also, but we should not forget that ‘developing’ means more than just in an economic sense; it’s also about the financial market generally. You can have all the growth you want, but without something you can own with confidence, it is not worth it.

Darek Kedziora, Aviva Investors – Hard currency as an asset class has been popular this year and for very good reasons. It provides the most stable risk-adjusted return. It’s attractive going forward. But probably local currency has the biggest potential. That comes with risk and there is much more volatility. But if the dollar is about to weaken, then we should expect EM currencies to perform very well. There’s been large inflows into hard currency but none into local currency, and we think if emerging markets remain attractive for investors, then local currency for next year should be more appealing.

In terms of countries, Brazil is looking very attractive. Russia, from a debt perspective, has been one of our top calls this year and remains so.

Robinson – India is another of our larger overweights. There are good companies there, but we are concerned about credit issues in the financial sector, specifically non-bank financials and whether problems will be contained to individual institutions, or if it is something that rolls through the financial sector into the higher-quality banks that are better capitalised. In the long term, we’re broadly positive on India. It’s a great consumer story, but in the short to mid-term, I’m a little bit anxious about how things will develop.

Funds Europe – Is China an emerging market or a separate asset class? With the increased weighting it’s going to have within the emerging markets index, it’s becoming a big player.

Thompson – It’s both, in that it is so big, it does stand alone within emerging markets. India has a strong domestic economy, but China is effectively choosing where it wants to go. It is definitely an emerging market, however. Most of the time when you’re meeting Chinese companies, you feel like you’re meeting emerging market companies, with all the positive and negative associations that has.

When you think about what makes a frontier market, or an emerging market or a developed market, it isn’t necessarily just the size of the economy. There are some massive frontier markets with extremely high GDP per capita, and people say, ‘Why are they frontier, not emerging or developed?’ The answer is that the market infrastructure or the corporate management regulations are poor. China fits thematically as an emerging market but it stands alone in terms of having the scale and global clout to make progress through the global economy.

Funds Europe – Let’s talk about frontier markets. Does it make sense to throw economies at such different stages of their development – Taiwan and Pakistan, for example – together under the emerging markets banner?

Kedziora – It builds on the theme of China. How do you treat China? Is it still an emerging market or is it a developed market? From a fixed income perspective, it’s really hard to compare China with anything else.

Within the EM space, you can build a portfolio up that is custom-made for whatever your objectives are. So, if you want low yield in safer assets, you can build it, picking countries that feed into your portfolio. You like stable income? Then you can pick countries that provide you with stable income. If you like high yield, there’s a big choice within the EM space.

Robinson – That’s how the industry is evolving, to some extent. We’re seeing an increasing awareness of factor-based investing and management of factor risks in portfolios. For instance, you may believe that a portfolio will have little exposure to the oil price if it contains few oil companies, but against that, if oil exporters dominate in terms of the country exposures, then a factor risk analysis will pick that up. In the future, I suspect clients will demand portfolios with specific factor-based exposures, rather than group everything under the broad banner of emerging markets.

Thompson – An index is a convenient tool and things are getting a lot more sophisticated. People can chop and change things to a large degree and can be quite client-focused. Products can be so cheap now that you can say, ‘Right, I want this factor within this type of market.’ I suppose to a degree, they’re all bunched together for people that want wider emerging markets, but thinking about the different ways you cut it, there are more developed and less developed markets.

You mentioned Taiwan and Pakistan. They are polar opposites, almost. And then you have the classic distinctions of domestic-driven economies like India versus the export-driven Russia. But then you’ve also got reliance on external capital – if you think emerging markets are more reliant on what’s going on with the dollar, or bond yields. Some are extremely reliant – Turkey, for example – whereas some are a lot less so. There are so many ways to cut it, which makes our jobs very interesting because there’s always something going on.

Patel – The index is flawed. It doesn’t represent the opportunity in emerging markets because it tends to be backward-looking. There are certain parts of emerging markets that are starting to exhibit the characteristics of a developed market but for technical reasons, some markets cannot be upgraded to developed-market status and linger around in the emerging market world. Taiwan is a fine example of this.

Emerging markets are not a homogeneous bloc; the index has 26 countries, 26 political dispensations and various cycles. The focus should also be on whether you are getting a real economic exposure to emerging markets. But I think what you alluded to is the currencies. In the past ten years, currency has been the single most important factor in terms of dragging down emerging market returns.

Kedziora – Traditionally, emerging markets had problems with current account deficits. Every time there was flight out of the emerging markets, they were on the verge of a balance-of-payments crisis, whereas there are structural shifts now and if you look at the positions of emerging markets as a whole, they’re net creditors. That is a fundamental shift. It also explains why, when you have a crisis in Turkey or Argentina, it doesn’t affect other countries as much as in the past.

Robinson – In the ‘taper tantrum’ in 2013, that was a classic contagion issue. We got a sniff that the Fed was going to reduce liquidity and eventually raise rates, then all the large current account deficit countries sold off hugely. That was quite problematic. We’ve had a similar scenario in 2018, which partly triggered the Argentina crisis and the Turkey crisis. Although there was some temporary contagion into Brazil and South Africa, it was nothing like what we saw in 2013. This reflects most of these countries getting their balance sheets in order and improving fiscal deficits.

Thompson – It’s just frustrating that EM has been underperforming. Argentina and Turkey were anomalies. There was a degree of panic, as always, but quite quickly the fundamentals, which are so much better, reassert themselves.

The dollar has been strong but, despite that headwind, emerging markets have been in the best possible condition. Those fundamentals were almost missed by the general market because everyone concentrates on the headwind. When it turns around, people will say, ‘Oh wow, things have really improved.’ Whether it’s corporate governance or macro factors, under the surface everything looks much better than usual – with a couple of notable exceptions that I think were distracting people less than a year ago.

Patel – The other issue is that we hold emerging markets up to the same standards as developed markets, which is unfair. The governance aspect has to be focused on a lot more for sure, because a lot of these companies are still owned by large, controlling, influential families or by the State. Having said this, we as the investment community and capital allocators have a huge responsibility to ensure that the overall direction of travel is positive. This is where our voice as shareholders can be very important. One size does not fit all and we as an industry must be careful not to succumb to groupthink around some of these issues.

Robinson – The industry has been on a bit of a journey over the last couple of years in terms of adopting more ESG into the investment process. We’ve historically focused a lot on the ’G’ – ‘governance’ – aspect of this, though we have introduced more environmental and social analysis into our process. It’s been useful from the perspective of understanding our companies better. It’s not just well-governed companies that we see as being high-quality, but also those that are managing environmental and social risks well. Analysis of these risks, and how they are being managed, gives another important source of information for determining the quality of a business.

Thompson – There are lots of buzzwords and some big companies possibly find it quite easy to tick boxes and say, ‘We know what we need to disclose, we’ve done this in a certain way.’ Whereas there will be a lot of emerging market companies that intuitively get this and do it well, but they maybe don’t have the resources to publicise it.

Funds Europe – What are the main risks and opportunities ahead for investors in emerging markets?

Thompson – It goes without saying that every market has its own specific dynamics. The global economic cycle remains probably the most influential factor on relative returns for EM. If you think of EM being effectively a value stock, you want to see yields picking up, you want to see manufacturing PMIs picking up. I guess that headwind for me has been the most obvious one that EM has struggled with. The trade war is part of that and has exaggerated this effect.

Just trying to be optimistic, it’s interesting that there has possibly been some tentative stabilisation in the indices. Looking at the number of PMIs that have been falling versus rising, that’s got to quite an extreme low level and it’s actually starting to pick up. There’s a lot of value there.

The macro is a risk. But when I’ve met clients, sometimes they say they like the long-term story but right now can’t buy into it because of, say, the trade war. Effectively I think they’re saying they’ll look at it again when it starts to work, but the thing about EM is when it works, it works really quickly. I feel that’s worth flagging now, that we’re starting to see stabilisation and risk is turning into, potentially, an opportunity. That’s going to drive the asset class as a whole, but within that, every market will have its own idiosyncratic drivers.

Robinson – There is a bullish case to be made until the end of the year. There is evidence that what we’re seeing is a mid-cycle slowdown. We continue to see easing from central banks. Leading indicators are picking up and we could even see a trade deal. So, there are several positive catalysts out there.

Kedziora – Historically, what has been driving EM as an asset class is beta to growth. And what’s been driving higher growth in the EM world was productivity growth and demographics. Both of those drivers are vanishing in many EM countries. Demographics will contribute negatively to growth. That creates risks for many countries in terms of getting out of the middle-income trap. At the same time, it could be an opportunity for fixed income investors.

Robinson – China is a good example of that: with their rapidly ageing population, there is the risk that China may get old before it gets rich – and get stuck in the middle-income trap with other emerging market economies. What is reassuring is that the government is making great efforts to avoid that by improving productivity. For example, each year four times more science and engineering students graduate than in the US. The absolute R&D spend by China is about to overtake the US as well, whilst there are already more people working in research there than the US. So there’s this huge investment going on in terms of productivity and wealth drivers, but there’s only a certain amount of time to do it.

Thompson – The previous cycle was very much geared to global growth, and one got used to this idea of demographics and productivity. In future, it will be more difficult.

One of the issues before was that growth came too easily, particularly in China. There was the whole sportswear phenomenon, four or five companies all selling tracksuits. Now it’s been whittled down to a couple of really good ones. Growth is good enough that you can do well as a company, but it’s not quite good enough that anybody can just step in. There was probably too much growth before, it was too easy, and now people are having to really think about capital allocation.

There’s still so much opportunity to consolidate fragmented sectors. China is much more comfortable saying, ‘We’ll grow at 4/5/6%’ than trying to get to 8% or 9%. In the previous cycle, we got used to wanting countries to grow as fast as possible, because surely more GDP is better for the market. But for corporate earnings you want good companies, consolidating markets, and when the going is tougher, the good companies become more interesting. They probably have a better opportunity to do that because it’s easier in emerging markets for a local player than it is for a developed market company to do the same. But it’s also not so easy that everyone can do it.

Patel – Just look at China: the median age is 39, similarly with Russia. Vietnam and India might still have about 30 as their median age. But that narrative of structural S-curves, J-curves or whatever, is passé.

Robinson – In the past it was hard to access the theme of domestic consumption within China. Unless you were able to get approval under their capital controls, you couldn’t invest in the Chinese A-share market, where most of the interesting companies are. However, with the advent of Stock Connect, we can. Given the structural flows going into those markets, and the fact there’s only a few blue chips which most large managers would be comfortable owning, it’s a pretty bullish outlook for those particular companies.

Vietnam is another really interesting country. They’re adopting more market-based reforms and there are some pretty decent companies there, particularly in the retail sector where you’ve got these low levels of formalisation. Small, well-run companies are really benefiting from that formalisation trend and the growing spending power of the young population.

Kedziora – We’ve been focusing on manufacturing exports, but we also see now that many countries are shifting to exporting services. There’s more and more share in global trade. CEE [Central and Eastern Europe] is a good example.

Funds Europe – Poland was recently upgraded to ‘developed market’ status in the first such promotion by FTSE Russell for nearly a decade. As the region develops, is Central and Eastern Europe still a land of opportunity for investors or is it largely overlooked, under-researched and undervalued?

Thompson – It depends how one classifies it. I think of Eastern Europe as being distinct from Russia. People that run CEE funds tend to have a lot of Russia in those funds, but largely Russia is a standalone market.

The other markets are largely overlooked. I’ll defer to anyone who knows about Poland, but there is quite a developed capital market, and pension funds. It could mean it is more developed in terms of capital market infrastructure relative to Russia or some of the smaller Eastern European markets. Just having a decent, steady investment flow of money from pension funds does make a big difference versus somewhere like Russia, where there’s more foreign investment.

Robinson – Most of the markets there would be frontier markets, like Romania, Croatia, Slovenia. We do go there every now and again, but frankly there’s just not an awful lot that we can invest in. Romania has got a subsidiary of SocGen listed locally, which is pretty decent. I’d say Poland has got a bunch of good companies. But yes, there’s quite a fiscal stimulus going into that market and into the economy, so there is a risk of overheating.

Thompson – It’s worth saying there are not many companies in Russia. I’m off to Russia in a week or two. I’m probably seeing a very good proportion of the companies in which you can possibly invest in just a few days.

Kedziora – From a fixed income perspective, the region now trades more in conjunction with what’s happening in the Eurozone rather than what’s happening in the emerging markets. But – and here I’m going off-piste because I’m not covering equities – I would say this is the market that I think global investors are overlooking.

If you look at Poland where the growth is close to 5% with inflation at around 2%, you cannot find too many other emerging markets – or even developed markets – which can show such figures. Some of that is fiscal stimulus, but you might overlook the structural change that happened to the economy over the last decade. It’s been like an economic miracle. When you’re investing in Poland, you’ll probably be looking at indexes dominated by the banking sector and energy sector.

These are not the sectors that are creating this growth. This is a pretty well-balanced and diversified economy, driven by small and medium enterprises.

Robinson – I suppose the indices have evolved quite significantly. Fifteen years ago, you would have found that the biggest drivers of indices were probably the commodities and materials sectors, so the indices performed well during commodity booms. But I think the big change over the last ten or 15 years has been new companies coming into the indices. The inclusion of Chinese internet companies is the big example, but similar things albeit to a smaller extent have happened in many other markets.

I started my career in US equities and I would say today the emerging market indices look much more like US equities did back then in terms of having so many different companies to choose from and not being restricted to just the big state-controlled commodity companies.

Funds Europe – Which countries do you see moving into that status from frontier markets over the next few years?

Thompson – What most people think of as frontier are Nigeria, Bangladesh – countries that look and feel like emerging markets but are really on the next rung down. Then there are other groups. Take Kuwait, which has high GDP per capita. The answer to why a country might be classed as frontier is that the capital market is underdeveloped, liquidity is low, or other specific technical reasons.

Patel – I think it’s irrelevant, to be honest. If you look at the recent examples of Argentina and Pakistan, it tells you just that. Whether an index provider decides to upgrade or downgrade should have zero influence on your active stock-picking (passive, of course, is different).

We have seen so much disruption in many of the recent upgrades where we see a big, non-fundamental bid-up in advance of the upgrade and then a big sell-off. Check the last few upgrades of UAE, Qatar and Pakistan.

Perhaps you can make money if you are a short-term hedge fund, but I do not think this is a sensible investment strategy and any stock-picker should never allow their decision-making to be influenced by what happens in the boardrooms of the index providers.

Kedziora – In economic terms, rather than technical terms, one example where there is a good chance of moving from a frontier to an emerging market is Ukraine, which is making really impressive progress in terms of reforms and fundamental improvements.

Technically it is a frontier market – definitely in fixed income. This year you can see a wall of money going into Ukraine local bonds. Positioning is becoming heavier – not to say crowded. But we think it’s justified. If you look at the progress they’re making, it’s quite impressive. It depends on the political determination, but everything is aligned.

Robinson – It’s not always a good thing when markets get upgraded to developed status. A case in point would be Israel, which used to be 7-8% of the emerging index and most managers had a couple of holdings in Israel. When that got upgraded to developed status, I think it ended up being less of a percent of the benchmark and most managers ended up selling those holdings. I don’t think liquidity on the local stock exchange ever really recovered from that.

Thompson – I feel like every time something gets upgraded or downgraded, you get a band of emails saying how much money will flow from it. But never has anything been such an obvious counter-indicator than that. Basically, that wall of money never really arrived because I think most people don’t need to worry about Pakistan, it’s like 0.2% of the index. Argentina is the same. Why bother? The existing investors move on and there’s nothing left and they get orphaned.

Funds Europe – Which events in emerging markets investing over the past decade have been the most instructive and what have you learnt from them?

Patel – Growth is not written in the stars!

Thompson – Back in the day, it was taken as a given that growth was on the table. Nowadays, decent but lower growth is probably more attractive and people have to think harder about how to allocate capital. Fund managers that are sophisticated about doing that will prosper under that environment. It effectively means thinking about companies in the same way you would about developed market companies: there are opportunities but who is going to benefit, who is doing well, who is thinking about things in the right way?

This is as opposed to maybe ten years ago when there was a dash for growth. To an extent, probably everyone is guilty of that. Whether it’s general investors or fund managers, all presentations would be, ‘Oh, yes, the Chinese middle class has got 300 million people who are buying contact lenses…’.

Robinson – Emerging markets have become a bit more like the US market in terms of company choice, but one of the key differences that remains is the governance structure within emerging market companies versus US companies. In EM, you have controlling shareholders, whereas in the US, it’s much more diffuse. The challenge has always been understanding those controlling shareholders and their motivations.

Maybe one of the big changes in the last few years has been the appearance of Chinese ADRs [American depositary receipts] and the challenge of understanding the governance of those companies related to the structures they use to get around foreign ownership laws. Ultimately it comes down to trust and whether we trust those individuals to treat minority shareholders fairly, even in the situation where a weak legal structure gives them that opportunity.

Kedziora – Maybe I’ll bring something more country-specific into the discussion, which I think investors will learn a lot from: Argentina. Again, you’re going to have a default in Argentina. If you look back to when [president Mauricio] Macri was elected, it seemed like Argentina ticked all the boxes which were positive for investors. It’s an example of how history repeats itself.

©2019 funds europe



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