Global investors see renewed promise in emerging markets
Updated 1.4.2018 at 9:42 a.m.
By Rex Mathew
By Rex Mathew
After nearly five years of underperformance, emerging market equities regained some favor from global investors in 2016 and have outperformed so far this year as well. Yet, many investors still worry about the risks, perceived as well as real. Is it yet another false dawn that could quickly fade when the United States Federal Reserve and other major central banks start scaling back their balance sheets? Or could the pessimism reappear if commodity prices falter again?
I believe emerging market fundamentals are much healthier now when compared to recent years. Helped by sustained gains in domestic demand and the recovery in export shipments, the economic growth outlook for the major emerging countries has brightened. I do see growth stabilizing in China, even as the country is rapidly shifting to a consumer-driven economy and several other Asian economies are accelerating. Domestic demand has become the growth driver for the emerging world and rate cuts by central banks are helping consumer spending. Commodity exporters are gradually recovering, as the demand outlook for energy and industrial materials continues to improve.
Finally, and perhaps most importantly, emerging market corporations are now growing more confident in their revenue and earnings growth outlook.
Growth differential with the developed world is widening
For nearly a decade before the 2008 global financial crisis, the appreciably faster economic growth in Emerging Markets attracted global investors. At the peak in 2007, emerging and developing economies were expanding at an annual pace of over 8.5 percent, compared to around 3 percent for the developed world. After the dip in 2008 and 2009, short-term fiscal spending by governments helped emerging economies accelerate again. However, as commodity prices started to moderate and global trade slowed, growth in emerging economies cooled off. In 2015, when the developed economies expanded at an average rate of 2 percent, emerging economies registered a not so impressive 4 percent.
Nevertheless, it now appears likely that emerging markets could regain some of the growth momenta and widen the growth differential with the developed world. The International Monetary Fund estimates that average the growth rate for emerging markets could rise to 5 percent annualized by 2019, and that rate could be sustained through 2022, while the developed countries are unlikely to expand faster than 2 percent. Though the pace is nowhere close to the pre-crisis high, even a moderate acceleration would be much appreciated in a world starved for growth.
Energy and commodity prices: not too cold, not too hot
The sharp decline in energy and commodity prices after 2014 did benefit large importing countries such as China, South Korea and India. But the abrupt fall in export realizations hurt Brazil, Russia, and other emerging countries, and pushed some of them into recession. The weak outlook forced energy producers and mining groups to cancel or delay capital investments, hurting equipment manufacturers and their supplies even in countries that have benefited from low commodity prices. On balance, the boost from cheaper commodities for the emerging world as a whole fell short of expectations.
Last year’s rebound in crude oil and other industrial materials such as iron ore helped the resource exporting countries recover from deep recessions. Brazil and Russia are expanding again, while most Latin American countries should grow faster by next year. At the same time, commodity prices have not moved high enough to appreciably detract from growth rates in China and other resource importers.
Governments in select countries are pushing reforms
After dramatically opening up their economies to join the globalizing world, and enjoying the growth boost afterward, governments in several emerging countries lost the urgency to initiate additional reforms to support businesses and make them more competitive. In some countries, governments became embroiled in corruption scandals and lost the political goodwill to make policy changes. The current governments in India and Indonesia did not have those constraints and have implemented significant policy initiatives, even at the risk of short-term disruptions to economic activity. Both governments have also proactively taken steps to reduce corruption and make it easier to do business in their countries. Similarly, several of the smaller Latin American countries are implementing business-friendly policies and reducing public spending.
Political risks in other emerging countries have also eased, though some of the governments have become more authoritarian and their policies have become somewhat unpredictable. Governments in Brazil, South Africa and Malaysia are facing corruption allegations, but the risk of these governments losing power appears low. If reform-oriented governments come to power in elections scheduled in 2018 and 2019, it is possible that some of these countries could see policy measures that enable faster economic growth.
Emerging market valuations remain attractive
Despite outperforming the developed markets for the last eighteen months, we believe equity valuations in emerging markets remain relatively more attractive and continue to offer long-term opportunities. Unlike earlier when most large emerging market corporations were energy or material producers in a handful of countries, investors now have the opportunity to participate in the growth of a broad array of industries and geographies.
To conclude, the economic and political environments in several large emerging markets have become more favorable for businesses to grow their revenues and earnings. Years of slow demand growth have forced emerging market corporations to trim their costs and become more efficient. Some of them have used this period to invest in capacity expansion that should help them grow their market share. We are now seeing clear signs of a revival in earnings, across most sectors, in emerging markets. If the environment remains supportive and the earnings cycle continues to revive, emerging market equities may deserve more favorable consideration from international investors.
The views expressed in the article do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Thomas White International or TEXPERS.