Oil, currency, China raise concerns, but EM undervalued
Emerging markets equities were volatile amid macro stresses in 2014, but rose 2.5% for the year through November. Sharp oil price declines in December tipped the scales and, as investor confidence wavered, the MSCI Emerging Markets Index went from year-to date gains at November-end to a 2.2% loss for the full year in US dollar terms. Emerging markets small-cap stocks rose for the year and outperformed their large-cap counterparts, helped by the MSCI Emerging Markets Small Cap Index’s lower allocation to energy companies. Emerging markets debt returns were mixed for the year, as US dollar–denominated assets advanced in contrast to declines in local currency denominated assets. Investment-grade debt significantly outperformed high yield debt.
The conclusion of emerging markets elections in 2014 is only the first chapter for many developing countries as the true test will be the progress elected leaders can make toward their mandates. The reform-minded premiers of India and Indonesia appear to be off to an encouraging start, while it remains to be seen what polices re-elected leaders in South Africa, Turkey, and Brazil will adopt to manage structural issues. The biggest risks we imagine for emerging markets in 2015 include a credit crisis in China, widespread recession, increased currency volatility (including a sharply rising US dollar), prolonged commodity price uncertainty, and further geopolitical destabilization in Ukraine, Russia, and the Middle East. On the other hand, we see opportunity in relatively low emerging markets valuations, economic growth that is still stronger than in the developed world, and secular consumer growth in many countries. Moreover, progress on reforms could result in a greater number of attractive investments in countries such as Brazil, India, Indonesia, and China. Market overreactions to headline events remain a classic source of opportunity as individual stocks are often indiscriminately punished in broad-based declines.
Double, double, oil and trouble
The halving of oil prices since their June 2014 highs has triggered a sell-off in developing markets stocks. Are these declines warranted? The net economic effect should be positive as commodities exports are either nonexistent or represent a small share of GDP for the majority of emerging markets (e.g., China, South Korea, Taiwan, Turkey), while they are a major component of other emerging economies (e.g., South Africa, Chile, Brazil, Saudi Arabia). However, commodities price trends have a disproportionate effect on emerging markets investor psychology. Historically, there has been a positive correlation between global commodity performance and emerging markets equity returns, butthe strength of that relationship has varied. Concerns about outcomes from extended oil price weakness have also weighed on sentiment.
It should be noted that cheaper oil creates more economic winners than losers in the emerging markets and should help bolster developed markets growth, primarily in Japan and Europe. From a consumption perspective, sixteen of the twenty three countries represented in the MSCI Emerging Markets Index are net consumers of oil, led by China, India, and South Korea. While in some of these countries lower oil prices could drive spending, as consumers realize savings at the pump; in other countries, such as India and Indonesia, it will reduce and possibly even eliminate oil subsidies, helping narrow current account deficits. (Fuel prices were raised to drive inflation in Indonesia, but fuel subsidies have shrunk.) Oil-producing states such as Saudi Arabia, Russia, Argentina, Iraq, and Nigeria will take big hits to revenues from oil taxes, but some of the bad news appears to have been priced in and, in some cases, possibly overstated. In terms of market effect, some strategists have noted that energy companies in Russia have been trading at valuations that imply oil prices of $25 a barrel.
The current oil price level should not be permanent based on self-correcting price mechanisms, however its duration is unclear. Unlike during the 1986 price shock when there was a disastrous confluence of oversupply and crumbling demand, world consumption is currently growing (driven by the economic ascendance and oil appetite of countries now considered emerging markets), albeit at a slower pace than supply. At today’s prices many oil projects are not profitable and capital expenditures will be cut, eroding future supply. On the demand side, rising wages in emerging markets should also support demand for oil which will help to offset declining oil consumption in Japan and Europe.
Some researchers believe persistent oil price weakness may pose a threat to US growth as high-cost US shale oil and gas projects become uneconomic, cutting off a major artery for new jobs in the US economy and, worse yet, causing job losses. The prospect of a widespread recession, with
Europe and Japan already on economic tenterhooks, would become more severe with US growth in question. This is a risk for emerging markets equities, which we believe require steady global growth free of exogenous shocks in order to significantly outperform developed markets equities.
Currency uncertainty, stronger economic frameworks
Lower energy prices should have a positive effect on macroeconomic variables like growth, inflation, and the current account balance, which should in turn boost currencies and interest rates. Given these macro tailwinds, however, the currencies of some emerging markets beneficiaries have not appreciated. We believe the currency market will eventually respond, but with a lag, as other factors tend to interfere with otherwise straightforward macroeconomic relationships. In reality, currencies are simply more sensitive to global risk appetite and US Federal Reserve policy.
From a macroeconomic perspective, oil-importing countries such as Turkey (which had a net energy bill of $50 billion, or roughly 6% of GDP in 2013) benefit significantly from lower oil prices. The impact is quick—falling energy prices help improve the terms of trade and ease pressure on the current account deficit. This helps stabilize the exchange rate, which amplifies the disinflationary impact of falling energy prices and boosts demand. In the case of the Turkish lira, however, a sudden hawkish shift from the Fed would neutralize any benefit to the currency. Weak emerging markets currencies and falling oil prices evoke memories of Asia’s 1997 financial crisis and Russia’s 1998 default. The Russian ruble has depreciated sharply, and investors have been broadly critical of the central bank’s interventions to stabilize the currency, which have also been viewed as insufficient. If capital controls are imposed, we believe they will be applied with care not to further alienate foreign investors, with lessons taken from Malaysia’s controversial 1997 defense of the ringgit from currency speculators. But there are critical differences that will help emerging markets weather the storm: (1) Most emerging markets countries have abandoned currency pegs for freely floated currencies, which grant all-important flexibility in a country’s economic and financial frameworks. (2) Emerging markets fundamentals are strong, and sovereign indebtedness has declined dramatically. Russia has reasonable debt coverage, with $388 billion of foreign reserves relative to $110 billion of external debt repayments consisting of external debt maturities of bank and non-bank entities in 2015.
Our equity teams are being selective with their Russian exposures, and their portfolio positioning differs as an extension of their unique disciplines, investment objectives, and investment processes. In the financials sector, there are opportunities in systematically important banks that have large deposit bases and liquid balance sheets. Our teams also see opportunity in defensive Russian businesses offering competitively priced, staple goods. Across the board, our teams are looking for companies well positioned to navigate Russia’s current challenges because of their strong balance sheets, good liability matching, and sound business models.
China’s long march
In China, rising wages have boosted incomes and willingness to spend. Consumption has risen since 2009, lending credence to the central government’s stated goal of pivoting to consumption-driven growth. The economic benefits are spreading to the country’s interior as tightening labor supply in the Pearl River Delta has prompted manufacturers to relocate inland. There are consequences, however. With an average worker earning between three to five times more than her counterparts in Indonesia, Vietnam, and the Philippines, Chinese labor is no longer cost competitive and China must ascend the value chain. It is already making headway. On a recent trip, we observed businesses setting up near universities in Chengdu to take advantage of a better educated labor supply. China has also established special economic zones with tax incentives to attract foreign investment. The property market, which has been the country’s biggest source of growth, is declining, but lower prices have also helped to clear supply in an overheated market. In addition, authorities have loosened margin requirements and lifted restrictions on mortgages on second homes to stimulate buying.
China is in many respects following in the footsteps of the Industrial Revolution. Challenges such as environmental and labor management, social safety nets, and displacement of jobs through mechanization will take time to work through, but its centrally planned economy also grants authorities more control over outcomes. Its financial frameworks are evolving alongside attempts to introduce open-market elements, and the quality of credit growth in the country has come under close scrutiny. We would not be surprised to see more debt defaults, but we believe authorities will be careful to prevent a disorderly unraveling.
Opportunity in an undervalued asset class
From the late 1980s through the 1990s, emerging markets stocks traded at a premium to developed markets stocks based on price to earnings. Between 1994 and 1995, the US dollar strengthened, the Fed doubled interest rates from 3% to 6%, and emerging markets equities underperformed their developed markets counterparts. Emerging markets equities have been trading at a discount ever since. As of December 2014, they were valued at 11 times forward earnings, 31% less than developed markets equities as measured by the MSCI World Index. We believe that this wide gap could help sustain emerging markets valuations in the event of US rate increases. Forward returns on equity in the emerging markets have declined since 2011, falling behind those of the developed world at 11.5% versus 12.1% at year-end, but are still strong. In an emotionally charged environment, the merits of bottom-up stock selection in the emerging markets can be pronounced. Our equity teams are adhering closely to the equity disciplines and investment processes that have served as a reliable compass time and again, especially in periods of uncertainty and market stress.
Paul Rogers is manager of the Lazard Emerging Markets Core Strategy