Long term structural case for emerging markets intact – Aberdeen AM
The declines in emerging markets cannot be solely due to the recent decisions taken by the Federal Reserve since performance has lagged that of developed markets over the last three years, according to Aberdeen Asset Management.
Weakness presents opportunity to invest in good quality businesses
In addition to tapering, a slowing Chinese economy and declining emerging market corporate profitability over recent years are all feeding negative sentiment and have led some critics to herald the death of emerging markets. The fundamental investment case for the asset class nevertheless remains intact.
Tapering: Strong domestic growth combined with weaker exports has contributed to a deterioration in the current accounts of many emerging economies. Plentiful capital inflows triggered by US quantitative easing helped fund this position, but resulted in an increasing reliance on foreign capital making these economies, in turn, more sensitive to the Federal Reserve’s tapering and rising US interest rates.
The key issue, however, is that economies are adjusting to less, and more expensive, capital. Emerging market currencies are now cheaper which should help boost exports, while higher rates will slow domestic growth and imports. This will eventually lead to an improvement in current account positions, underpinning currencies and allowing interest rates to come back down. In addition, the events of recent months have reminded policymakers that they need to compete for global capital which will likely prompt progress on further constructive reform within emerging markets.
China: The government is pursuing interest rate liberalisation and consumption-led growth as a means to address the fundamental misallocation of capital that has seen ballooning credit produce less and less growth in recent years. This has consequences for global and emerging markets growth as China’s economy slows and the nature of its imports change, for example the country’s vast investment-led hunger for natural resources, and brings to the fore concerns over bubbles in the economy and, in particular, the property market.
Yet the administration has the scope and tools to stimulate the economy if it slows too much. The banking system remains well capitalised to handle the current difficulties and a closed capital account gives the authorities greater control of the situation. Ultimately the reforms, if pursued, will provide better investment opportunities in China.
Corporate profitability: Emerging market corporate profitability has declined as companies have had to contend with slower economic growth and margin pressures from rising costs. In contrast, developed market companies, particularly in the US, have seen profitability hold up as they have taken costs out of their businesses and have implemented significant share buyback programmes.
Encouragingly the recent difficulties faced by emerging market companies will refocus the attention of management on margins and removing excess costs. Consequently, once the cyclical slowdown turns into an upturn, companies should report stronger topline growth as well as widening margins which will drive a strong earnings recovery.
The fundamental long-term case for emerging markets remains in place. Imbalances that exist are not as pronounced as in some developed world countries; economic growth is stronger, demographics are generally positive and companies are in good shape financially and are well positioned to capitalise on rising consumer wealth and opportunities in overseas markets. Furthermore, the contagion effect is far more contained as the economies are in a better position to handle the current problems than they have been in the past. Both emerging market policymakers and corporate management are well experienced in handling these periodic crises of confidence and we have every faith that they will rise to this latest challenge.
Emerging markets have a track record of volatility yet Aberdeen Asset Management’s Head of Global Emerging Markets, Devan Kaloo, believes the outlook is more positive than some market participants claim: “There’s no doubt emerging markets are having to face up to some tough challenges. Fed tapering is making them realise they’re in a global competition for more expensive capital. Concerns over bubbles developing in the Chinese economy are feeding worries about the growth picture and emerging market companies have been slow to react to weaker economic conditions.
“However, emerging markets are in a stronger economic position than they have been. There are no major economic imbalances, debt and fiscal levels are far from crisis levels and policy rates are still largely accommodative. Companies too are well positioned to adjust. It must be remembered that emerging markets have a history of scares and what follows the latest bout of uncertainty will merely be a natural and healthy adjustment.
“Policymakers and company management are more than equipped to deal with cyclical change – they have been here before. Current volatility is spurring reforms both at the government and company level, while China’s slowdown and any asset bubbles should not threaten the country’s financial system. Far from being the death of emerging markets, the current volatility presents opportunities to invest in good quality companies – a lot is already in the price. We believe this focus on fundamentals will serve investors well in the long run.”