Is it time to buy emerging markets?
It seems fitting that 2018 was the Year of the Dog in the Chinese zodiac. Most asset classes fared poorly this year as investors hit the panic button, but the pain has been particularly acute in the emerging market sector. Notwithstanding a few months of recent relative outperformance, EMs as a whole have dramatically underperformed the broader averages over the past several months. For example, while the S&P 500 stock index has declined by 2.9 per cent year-to-date, the MSCI emerging market stock index is down 16.4 per cent, representing underperformance of 11.4 per cent as of this writing.
To a large extent, 2018 has been a perfect storm against the EMs. The strengthening greenback, rising trade war tensions, geopolitical upheaval and collapsing oil prices have been major headwinds. China, by far the largest of the EM countries, has lately been the whipping boy of American politicians and the clear target of Trump’s aggressive trade negotiations. Looming uncertainties over trade policies and growth have curtailed business investment creating poor sentiment for investors. Also, China and the other EMs are experiencing slower rates of GDP growth than they have enjoyed in the past.
Yet despite modestly decelerating growth in the world’s second-largest economy, economists expect China’s gross domestic product to advance at a rate of about 6.6 per cent in 2018 and 6.2 per cent in 2019, more than double the rate expected for the developed world as a whole using Bloomberg consensus data. Next year, aggregate emerging market GDP is expected to advance at a rate of 4.7 per cent, compared to 2.1 per cent for developed countries, as forecasted by the International Monetary Fund.
Beyond the raw GDP growth statistics, people in the EM countries are getting richer and the trend towards a rising middle class continues to provide a unique investment opportunity. According to the IMF, emerging markets are expected to represent 58 per cent of the world’s middle-class population by 2030, up from just 27 per cent in 2009. China and India’s middle class are expected to reach nearly 800 million people and will eventually represent two of the top three largest middle-class populations in the world by 2020. A growing middle class typically helps fuel economic growth. For example, on November 11, online sales during China’s Singles Day totalled $42.4 billion, a 27 per cent increase over last year. Consumer spending in areas such as clothing, electronics, entertainment are a good indication of where the economy is heading.
Front and centre in the debate over EMs’ attractiveness is an apparent push away from globalisation and towards greater nationalism, at least with respect to the US. Underscoring Trump’s trade war is his commitment to bringing manufacturing back to America and away from the many countries which have greatly benefited from outsourced American production over the few past decades.
A central question for the future may be: can the EMs prosper on their own? Indeed, China’s Belt and Road initiative appears to have the country heading in this direction. China has spent more than $4 trillion in building out its global infrastructure across 60 different countries as a means for distributing its products globally, and America is not one of these destinations.
Looking at the EMs’ stock markets as a group, the median price-earnings ratio on forward earnings is approximately 11.5 times. This ratio compares to approximately 16.5 times for the S&P 500 index. Trading at a 30 per cent discount to the S&P, EMs are currently priced at relatively cheap levels. EMs have historically traded below US P/E ratios but the current discount represents a discount of about 10 per cent to the median over the past decade.
One issue holding back Chinese shares has likely been inconsistent profit performance. Chinese corporate earnings experienced almost no growth between 2012 and 2016. However, earnings did begin to ramp up in 2017 and have remained solid throughout 2018. Corporate earnings are expected to accelerate from 13.4 per cent growth this year to 14.2 per cent in 2019 according to MSCI data and some analysts believe drivers of that growth still have a long way to run. China has many levers to pull in the direction of stimulating their economy and companies able to tap into the growing consumer spending that accompanies rising incomes have the most to gain.
Of course, a major area of concern is the final outcome of the ongoing trade war between the US and China. Investors are wary of the recent US-China trade truce outlined at the G20 meeting in Argentina for several reasons, including a lack of apparent agreement on details and a new hardline US negotiator.
However, there is reason to believe we get a workable deal in the near future. As long-time investment strategist and Blackstone Group vice-chairman, Byron Wein, pointed out in a recent CNBC interview: “China and the US both need a deal and when both sides of a negotiation come to the table looking for a positive outcome, you usually get one.” Personally, I believe President Trump is first and foremost a dealmaker who desperately needs an agreement to bolster his increasingly tenuous grip on Washington and to have a shot at a second presidential term.
Some of the more constructive commentary from both China and the White House in recent days may be pointing in this direction. China is already talking about reducing its US automobile import tariffs, cracking down on intellectual property theft and is already buying US agricultural products once again.
In any event, China has an agenda which will not be as export dependent in the future. Selling to the country’s own middle class while economically annexing neighbouring countries looks to be part of their longer-term strategy. Clearly, exports have become a much smaller part of the country’s GDP growth. Over 70 per cent of China’s GDP growth for the first three quarters of this year came from consumption rather than exports or government spending as they have in the past.
Meanwhile, retail sales in India are expected to almost double from $600 billion to $1 trillion by 2020. The rise may be driven by improving incomes, digital innovation and mobile wallets in the e-commerce and Brazil’s outlook has been improving since after its October presidential election.
Emerging markets selectively offer value at these levels and as an asset class have historically been a good portfolio diversifier. However, investors must be willing to accept a higher-than-average degree of volatility as geopolitical uncertainties are likely to persist.
• Bryan Dooley, CFA is the Senior Portfolio Manager and General Manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information
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