By Allan Conway, Head of Emerging Market Equities at Schroders
Why have GEMs underperformed? It is probably fair to say that many investors accept that the long-term structural case for emerging markets remains intact. Superior economic growth driven by favourable demographic trends and strong balance sheets means the centre of gravity of the global economy will continue to move towards the emerging world.
Over the last 15 years or so GEM real GDP growth has, on average, been 3.2%1 higher than developed growth. According to the International Monetary Fund this premium growth rate is expected to continue for the next five years at least. Furthermore, GEM has and continues to account for approximately 60-65% of global GDP growth. This is largely due to an acceleration of consumer spending and investment. In other words, it is a greater reliance on domestic consumption rather than simply exports to the West that is driving GEM growth.
So why is the MSCI Emerging Markets (EM) index down 6% since the end of September 2010 when the MSCI World index is up 35% (both in US dollars)? Part of the explanation is that markets react to rates of change and expectations rather than to absolute levels. For the last three years GEM has struggled in this regard. Both GDP and earnings have surprised on the downside in GEM, but on the upside in developed. The main reason for this is that even though a disaster was avoided as we emerged from the financial crisis, investors were pessimistic about the prospects for the developed world and optimistic about GEM. This was certainly correct in 2009. Growth in GEM rebounded sharply in response to massive stimulus, but the developed recovery was, and remains, anaemic. The problem is that after the initial recovery, the anaemic developed world recovery has actually been better than those very negative expectations and the GEM growth rate has faded somewhat, particularly as China began to tighten in 2010. Growth surprises have been moving in opposite directions.
GEM earnings have also been relatively disappointing. Top-line revenue has fallen short of expectations and margins have been squeezed in the emerging world as costs, particularly wages, have increased. In the developed world, costs have been contained and margins have been maintained; for example, profits as a share of GDP in the US remain elevated. So GEM earnings have also underperformed versus developed and there is a close correlation between relative earnings and relative market performance.
A key reason for slower-than-expected growth in China has been the measures taken to rebalance the economy. It has been well documented that China needs to reduce dependence on fixed asset investment as a driver of growth and shift towards stronger consumption. The surprise has been that the new leadership appears to be pursuing this more aggressively than expected. As a result, demand for commodities has softened at a time when new supply is coming onto the market. Consequently the commodity producers in GEM have felt the impact.
The above trends have resulted in capital flowing from GEM to the developed world, and in particular to the US. As a consequence the trade-weighted US dollar has strengthened. This has put further pressure on GEM as a stronger dollar typically results in tighter policy settings in the emerging world.
Finally, comments from Ben Bernanke on May 22nd suggesting that the Federal Reserve Bank could begin tapering its quantitative easing (QE) programme in the not-too-distant future have negatively impacted those emerging countries reliant on short-term flows to fund large current account deficits. Despite a strong consensus that tapering would begin in September, this did not happen. Attention has now switched to December, but in the meantime GEM in general, and the countries with large current account deficits in particular, have rallied strongly. We believe this is just a short-term bounce and is not to be trusted. Near-term a number of headwinds remain. The structural problems in Europe are being addressed, but progress is slow and issues could easily resurface. The withdrawal of QE has been delayed but not cancelled, and any aggressive unwinding of the significant emerging debt holdings built up by foreign investors could still be extremely disruptive for certain emerging equity markets.
Therefore our GEM portfolio continues to be cautiously positioned for now. The beta is a little below one and we are underweight deep cyclicals such as basic materials stocks.
That’s the bad news. The good news is that much of the above has been reflected in market moves, which is why we are cautious rather than bearish. For example, looking at forward price to earnings ratios we find that the MSCI EM index is trading at around 10 times the next 12 months’ earnings. This is at a significant discount to both its history and to developed markets.
On a price to book (PB) basis we see the same large discount to history. The current PB ratio is around 1.5 times, which is close to 1 standard deviation below the long run average of around 2 times.
While these valuations are not yet at rock-bottom levels, they are not too far away. Over the last 20 years or so emerging markets have traded at or above these levels 80-90% of the time. Moreover, on the few occasions when GEM has been below these levels, the returns over the following 12-36 months have always been strong.
In addition, as a result of the significant devaluation of the currencies of a number of countries running large current account deficits, the exporters in these countries are now much more competitive and better positioned to benefit from any recovery in global growth.