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BRIC And Mortar: Recent Challenges Aside, Opportunities Abound

Emerging Markets (EM) equities continue to be an exciting area of opportunity in 2016, even though performance overall has been challenging over the past 5 years. The long-term case for EM equities, which is broadly similar to that of EM debt, remains intact and, if anything, is now stronger given the relatively attractive valuations seen in EM equity markets.

While valuations measured by P/B and P/E have increased steadily in the US since 2009, P/E has moved sideways and P/B has decreased for EM equities. By May 2016, the P/B ratio for the S&P 500 is estimated by Bloomberg at 2.78x, which is about twice the P/B for the MSCI Emerging Markets Equity benchmark of 1.38x.

Obviously, we have arrived at this valuation gap via negative returns from EM equities. With the exception of 2012, when EM returns were up in the high teens, 2011-15 were years that generally saw negative performance, despite experiencing a small rebound in 2016, with year-to-date returns of about 1.5%. The recent performance pattern has generated negative sentiment towards EM equities which has been largely fueled by challenging news on the political and economic front across the so-called BRIC countries (Brazil, Russia, India and China) over the last couple of years.

In 2014 the world saw Russia invade the Crimean Peninsula in Ukraine, sparking a series of sanctions that translated into poor market performance. The subsequent decline in the price of oil further deepened the challenges faced by the Russian economy to the point that this once titan of Emerging Markets has been reduced to a weight in the MSCI EM benchmark of only 4%, compared to more than 10% before the Global Financial Crisis of 2008.

In a similarly unfortunate way, Brazil, once considered an area rich in investment opportunities, saw nearly all politicians in the country (including the President) embroiled in a political scandal and suffered a negative shock due to the rapid decline in oil prices. While Brazil has recovered strongly in 2016, the country has produced negative returns (-39%) over the last two years.

The story in India has been more positive. India was broadly cited as a member of the “fragile five” during the so called “taper tantrum” in the US in 2013. Since then, however, the balance of payments has increased dramatically, driven by a reduction of the current account deficit combined with steady (and marginally growing) foreign direct investment (FDI). The victory of the right-wing Bharatiya Janata Party in 2014, leading to the appointment of Narendra Modi as Prime Minister, increased market optimism, particularly given Modi’s track-record of support for businesses and the prospects of structural reforms in the world’s largest democracy. Over the two-year period ending May 2016, India is the only BRIC country with positive returns (4.58%) and a clear outperformer versus all other Emerging Markets countries.

Meanwhile, China’s market has been more mixed and a true rollercoaster. Most international investors are exposed to H-Shares (Chinese companies with listings in Hong Kong); in spite of that, news reports globally and some market participants have focused on volatility in the A-Share market, which appreciated by 77% from June 2014 to June 2015, only to retrench 35% since then. That said, H-Shares also suffered from negative returns in the last year (-32%) so the markets are flat relative to 2 years ago.

Over the last year, the sentiment towards China has deteriorated dramatically. Market participants have long questioned the validity of official economic data and many have resorted to tracking other metrics as a proxy for economic growth. Around mid-2015, investor concerns regarding a hard landing in China worsened, driven by a number of bad economic data points (including PMI); and, as a result, both A and H shares started a steep decline. In December 2015 China announced a change on their reference basket for currency value, effectively removing the focus on parity against the USD which led to some unwarranted appreciation of Chinese currency versus regional competitors. The government then increased the flotation band for the currency, leading to a devaluation.

By the time China announced its stimulus plan in March 2016, investors had already accepted the notion of a slower growing economy with a currency that now looked vulnerable. As such, markets started to recover. However, a good portion of the economic stimulus in China occurred via government-owned banks that lent money to targeted companies, leading to a massive credit expansion and concerns over a credit bubble. China’s real estate market, in tandem, is also showing signs of an impending bubble, not just because of overdue appreciation but because many of the newly built properties that are still vacant. These concerns have prevented the market from further appreciation, and H-Shares are now trading at a discount to broader EM at 1.29x (vs. 1.38x) P/B and 10.3x (vs. 13.8x) P/E.

Opportunities In China and Frontier Markets

The opportunity in Chinese equities, however, is extremely attractive. While the credit cycle is likely to be challenging, the reality is that the Chinese government appears to have a formidable set of tools to manage most crises. These include international reserves in excess of US$3tn, a CPI that is well under control, and a very positive balance of payments made primarily by a positive current account (even with an overvalued currency). China, meanwhile, is transforming its economy from manufacturing-led, where the added value is medium to low, to consumer-led, where corporations (public and private alike) are more likely to capture a bigger share of added value.

One of the reasons why China (and EM in general) does not look more attractive on a P/E basis is that earnings for listed companies have declined in recent years. This decline is not driven by top-line growth but rather by declining margins. In the particular case of China, a big driver for declining margins has been the dramatic growth in wages, which have increased almost 15% on an annualized basis since the early 2000s. This shift is putting a tremendous amount of wealth in the hands of consumers.

The Chinese transformation has further implications for Asia. As the Chinese economy focuses more on consumers, Bangladesh and Vietnam have been willing to take on the manufacturing role that China once held. Given the relatively low liquidity of their equity markets, these two countries are generally outside the scope of traditional EM equity managers and more associated with Frontier Markets. As a result, there is a big opportunity for stock selection to be considered on top of the secular transformation trend in those economies. Other parts of the world –like Sub-Saharan Africa, Argentina and smaller countries in Eastern Europe- also share in this trend, each one of them benefiting from their increased ability to integrate into a globalized economy. These countries, referred to collectively as Frontier Markets, present some of the most exciting opportunities.

The positive cyclical improvements across Asia is reverberating across the world. Asia represents close to 70% of the major EM equity indices and as these countries move into more positive parts of the cycle, they are likely to influence the sentiment towards emerging markets in general. Russia is also influential in this regard, but the ghost of sanctions is starting to dissipate and oil is starting to stabilize, enabling the country to produce returns of 17% year-to-date in 2016 through May. Brazil has moved to impeach its president, stirring renewed optimism around positive reforms; this coupled with low valuations in the market has produced a strong rebound of 39% year-to-date through May, making it one of the best performing countries in the world. China and India equity performance has lagged in 2016, but this should be viewed as an investment opportunity as those two countries present some of the most dynamic cyclical improvements.

With improving sentiment, attractive valuations and positive cyclical developments, emerging market equities represent an exciting investment opportunity in the years to come; the Chinese credit cycle is perhaps the biggest risk to this thesis, but the positives and the ability of the government to manage them mitigates it to an extent. As earnings begin to improve in emerging markets the opportunities for stock selection will be vast, adding potential return to an already attractive beta case.

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