Having underperformed the US market in the three years prior to 2016, emerging and frontier markets began to outperform both 2016 and 2017. Naturally, whenever you have a bull market, there are always fears that the bullish trend will not last, and there are many detractors who will find reasons for an end to the positive sentiment.
It's important to look at what market advisors and traders are saying and how bullish they are on the markets. If, as some commentators say, the sentiment is at 10-year highs, we normally would want to be concerned. The belief that “bull markets die on euphoria” is certainly relevant, particularly if we link that to the fact that yields on junk or high-yield emerging-market corporate and sovereign bonds are at historically low levels.
The detractors point to China as the country most likely to generate shockwaves through emerging markets. This is important since China now represents the world's largest emerging market and has the highest weight at 30% in the MSCI Emerging Market Index followed by Korea at a distant 16% and Taiwan at 11%. The critics point to an ongoing government tightening in China that should result in slower money growth. They say that only if the velocity of money rises significantly will the drop in money growth be negated. Therefore, they state that there's a good chance that Chinese economic growth will slow.
Of course, we know that the GDP growth rate in China is decelerating and this is natural since the total size of the economy has grown significantly. But a slower growth rate does not mean less dollars are generated by the economy. China’s10% growth in 2010, translated into dollar terms, was less than the 7% growth in 2017. With an expanding size of China’s economy is able to generate more growth in value at even a slower growth rate.
The naysayers also point to the fact that there is an in an enormous overhang of money and credit in China, which has resulted in various imbalances such as high property prices and excessive/wasteful spending on overseas assets. We have already seen some Chinese corporations get into trouble and this is likely to continue. Given the size of the Chinese economy, we can expect problems with some overleveraged companies. Nevertheless, we must remember that China is still a planned economy and the major levers of financial power are in the hands of the government – as a result of their control of the four largest banks, the major insurance companies and the huge state-owned enterprises.
Needless to say, there is also USD3tn of international reserves. More importantly, the Chinese authorities are certainly aware of the risks and are taking strong measures to correct the imbalance. One important step has been to attack corruption in the government as well as forcing banks to bring their off-balance-sheet assets into their balance sheets and taking measures to rein in the so-called shadow banking activities. All the financial anomalies are part and parcel of the economy that is liberalizing financial markets and placing more emphasis on growing a strong consumer economy and private sector.
Another argument detractors have is the tremendous growth of information technology stocks particularly the Internet related stocks in emerging markets, which now represent the largest sector weight in the EM indices at a weight of 28%. One of the major Internet stocks in China has seen its share price shoot up 11-fold since January 2010. So the argument that we are in a “market mania” is hard to refute. Of course, few are willing to bet that the upward trajectory will end in 2018 or, conversely, continue for a number of years.
For value investors the P/E multiples and other value indicators are certainly looking overvalued when compared to previous valuations. Still, history has shown us such overvaluation can be sustained for a long time, particularly if the companies in question continue to increase their earnings at a dramatic rate or capture the imagination of investors, so that projections five or 10 years out are accepted by the market.
Related to these valuations are the very low interest rates that have been experienced in recent years. The world's central banks have been feeding markets with liquidity and pushing down interest rates to extremely low levels. Valuations such as the price-earnings ratio must be related to interest rates levels. We only need to take the reciprocal of the interest rate to get one indicator of where P/E levels can be justified. When the interest rate is at 1% the reciprocal of 100x’s can be argued as a “safe” P/E level. A rate of 5% can justify at P/E of 20’s.
When we look at various value indicators for emerging markets versus developed markets we see that the average price-to-earnings multiple for emerging markets, as of the end of 2017, was about 12.7 times versus 16.9 times for developed countries; earnings-per-share growth was running higher at 13.4% for emerging markets versus 10.6% for developed countries; and the return on invested capital was higher at 7.1% for emerging markets compared to 5.8% developed markets.
The next question is how long will the low interest rates last. Expectations are clear that the Fed in the U.S. as well as the European Central Bank are on the path to disposing of the pile of assets they have acquired in the past few years and are in an interest rate hike mode. If we look at frontier markets, we can find even cheaper valuations, which could be resistant to interest rate hikes. So we need to continue to look at interest rates and bond yields. Many detractors feel that a small rise in long-term bond yields could lead to meaningful P/E de-rating.
One gauge of expected emerging markets performance is to examine the global spread between global bond and emerging market bond interest rates. Normally, as the spread narrows, that is as emerging-market bond rates begin to converge with the developed market bond rates, there is bullish sentiment in emerging markets. But when the spread is high, emerging markets tend to underperform.
For example, in 2008, spreads rose to as high as 8% and the emerging markets index fell dramatically to below 1000 points from the high-point of about 2800. But then, when the spread fell to about 3% in 2010, emerging markets recovered to a level of 2200. Currently the spread is about 3% and emerging markets have risen to an index level of about 2500. Any loss in confidence of emerging market bonds relative to global bonds could result in the spread widening and emerging markets stock indices suffering. There is no indication that that this is going to happen anytime soon, but it is something to keep in mind.
One significant aspect of the equity markets is the dramatic rise of passive funds particularly exchange traded funds (ETFs). According to the Investment Company Institute, in the year 2000 ETFs were valued at USD66bn, less than 1% of the USD6,695bnof mutual fund value. But by 2016 ETFs were USD2.524bn or 15% of the then USD16.344bn mutual fund market.
More importantly, the largest part of new fund flows are going into ETFs. ETFs follow the indices and the money goes into those indices regardless of what the valuations may be. So, the relevance of what value investors may consider excessive is ignored and the only relevant fact is the index level. ETFs investments will not be constrained by value considerations.
Regardless of what the short-term assessments may be, from a long-term perspective emerging markets and frontier markets continue to look good not only because they are growing at a faster rate but because they are growing in total value terms. In 1987 the total market capitalization of emerging markets was USD272bn, but today the market capitalization is about USD20tn.
Emerging markets have more to go because their capital markets are not fully developed. Emerging stock market capitalization is now 104% of GDP while in developed markets it is 117% and frontier markets capitalization total is only 32% of the GDP of those countries. That's one of the reasons why we're so excited about the growth potential of frontier markets. In 1987 the total GDP of emerging market countries represented about 19% of the world but by 2016 it had risen to 42% of the world.
Another important aspect is the stronger financial stability that we see in emerging markets. In 1995 foreign reserves in developed market central banks amounted to about USD1tn, while in emerging-market countries it was about half of that. But by early 2017 foreign reserves in emerging markets had surged above that of developed markets reaching about USD7tn, compared to only about USD5tn for developed countries. Public debt as a percent of GDP in emerging markets has actually fallen from about 50% in 2008 to currently about 35%, whereas in developed markets the share has gone from 65% to 100%.
Most significant is the gap in GDP growth between emerging and developed markets: for 2018, we project a growth rate for emerging markets averaging at 4.3% whereas for developed markets it will be only 2%. It is not surprising that emerging markets are growing at that high pace, not only because they are starting at the lower base, but also because they are benefiting from the so-called demographic dividend. The emerging markets population median age is 32, and 26 for frontier markets, compared to 41 for developed markets. In other words, the vast majority of the population in those emerging and frontier markets are entering the most productive years of their lives. And there are more of them, because the total population of emerging markets now is 5.9 billion compared to 1.4 billion for developed markets.
There are two areas where misunderstandings regarding emerging-market correlations arise. One of these is related to commodity prices. Many investors believe that when commodity prices decline, emerging markets suffer. This is a misunderstanding of causation and correlation. Yes, there are times when commodity prices fall or rise, and the emerging-market industries move in the same direction. But this is not a consistent relationship, and drawing causality is a mistake, because if we consider the emerging markets largest commodity consumer - China - a fall in commodity prices should actually be beneficial to that economy. This is true for a number of other emerging markets who are net importers of commodities and thereby should benefit from a fall in commodity prices.
The other misunderstanding comes from relating interest rates to emerging-market behaviour. When we examine the U.S. Federal Reserve’s fund rate since 1988 and relate it to the behaviour of the emerging market index, we find that there is no consistent correlation. Between 1988 and 1992, when the Fed funds rate was falling, emerging markets stock prices rose, as was expected under the theory that lower interest rates are good for stock markets. But between 2003 in 2007 when the Fed funds rate was rising emerging markets were experiencing a big bull run just when you would expect the interest rate rise would damage emerging-market sentiment.
The most significant growth accelerator for emerging markets is, arguably, now coming in the form of the Internet. Its impact on the spread of knowledge and information is inestimable and emerging-market countries are embracing the new technology in a big way. In 2016 emerging markets were outpacing the developed countries in terms of Internet usage. China was taking 21% of the total global usage, India 14%, Brazil 4%, Nigeria 3%, and Russia 3%. This was compared to 9% in the US, 3% for Japan and 2% each for the UK, Germany, and France. Smart phone sales are accelerating the trend towards more emerging market access for emerging market consumers because of the plummeting prices. In 2008 about 100 million smartphones were sold of which 37% went to emerging-market countries. By 2017, 1.4 billion phones were sold but the vast majority, 72%, went to emerging-market countries.
No one can predict with accuracy what is going to happen in 2018 simply because there are so many outstanding factors that could impact all markets, not just emerging markets. However, we can say that regardless of short-term events, emerging and frontier markets have a bright future and temporary setbacks will not affect that optimistic outlook. Examination of emerging markets shows us that bull markets last longer than bear markets and the bull markets go up in percentage terms much more than the bear markets go down. Long-term investors in emerging markets, therefore, are in a strong position to benefit from the bright prospects we see for emerging and frontier markets.