- We see emerging markets shifting from an environment of common thematic tailwinds to one of more idiosyncratic outcomes
- We believe that painting all emerging markets with a broad brush is a mistake
- We examine some of the key factors in uncovering EM investment opportunities
Emerging markets (EM) is a term given to a universe of countries that is extremely diverse across a wide number of variables including geography, levels of industrialization and political systems. Despite this diversity, emerging markets are often discussed as if they are a homogenous block, particularly in the context of broad asset allocation decision making. We think that’s a mistake. Instead, we see opportunity from applying a more bottom-up approach to country, industry and security selection amidst growing dispersion in outcomes across the emerging world.
It is not surprising that many investors may see EM as a highly correlated block. During the past decade, cross correlations between country equity indices doubled from the previous decade and individual security correlations moved similar orders of magnitude in equities and fixed income. The convergence of outcomes was largely the result of some common factors heavily influencing the broad EM growth story. Those factors included the positive effects of reforms stemming from credit and currency crises of the late 1990’s, the rise of outsourcing and low-cost manufacturing, record commodity consumption from China’s infrastructure and capacity building binge, and easy access to cheap funding from the developed world. However, these factors are rapidly evolving and having dramatic impacts on the emerging markets. The Chinese-led export model is faltering on declining global competitiveness and the limits of operating at razor-thin margins (or even subsidized losses). China’s broad over-capacity and credit challenges have brought an end to their voracious appetite for commodities. The beginning of Federal Reserve tapering has raised concerns about the availability of cheap external financing of growth, particularly for countries in current account deficits. Finally, the commitment to ongoing reforms and governance progress ebbed through the decade as seemingly abundant growth and distance from earlier crises reduced the level of urgency in many nations.
Investor concerns regarding these developments have led to a broad valuation retreat in EM. Valuations in fixed income and equity markets, which had managed to significantly close the gap with their developed market peers, have gapped out again. That is why we strongly believe that painting all of EM with a broad brush is a mistake. The challenges for many EM economies in this environment are real, but within the vast universe of EM, there are countries, industries and companies with differentiated fundamentals, trading at valuation levels not seen in some time. So what we are looking for in terms of differentiation at a country level?
• Globally competitive manufacturing focused economies vs. commodity focused exporters. A return to growth in the developing world will benefit stronger emerging manufactured exporters from the emerging world.
• The direction of current account deficits and ability to attract foreign direct investment. While there is legitimate concern about levels of external financing in some markets, it is worth noting how much stronger the situation is in Southeast Asia, for example, relative to the crises of the late 1990s.
• Countries that saved and wisely reinvested their commodity windfall vs. those that did not.
• Perhaps most importantly, countries undertaking structural reforms vs. those continuing to delay or backsliding on economic policy. Mexico is the poster child for positive economic reforms with the recent passage of fiscal reform and the watershed energy reform bill – easily the most important reforms the country has seen in decades. The Philippines and even much maligned Indonesia – with recent land reform bills and removal of energy subsidies are making moves in the right direction. 2014 will be an important year on the reform front – execution of the Chinese reforms are obviously on the market’s mind, but presidential elections in India, Brazil, South Africa, Indonesia, Turkey and possibly Thailand have the potential to increase volatility, but also open a window for reforms to gain momentum if the ruling party wins with a strong mandate.
On the point of reforms, abundance and hope of continued growth seem to have bred complacency in many countries. Consumers in certain nations spent beyond their means and governments made promises such as establishing pension systems and welfare benefits that will be hard to keep should the pace of growth slow. However, some leaders are willing to push forward reforms, sometimes difficult ones, and from these valuation levels, such moves can be richly rewarded. For example, even the tentative steps toward reform in India have resulted in significant outperformance of peers in recent months. Longer term, look at the divergent paths of neighbors Colombia and Venezuela. Governance and reform matter a great deal. The ultimate confirmation of the power of consistent commitment to governance and reform has been Singapore’s march From Third World to First (the title of a highly recommended memoir of that path by Lee Kuan Yew, the remarkable city-state’s founding father).
Keep in mind that even within countries, there are many dynamics at an industry and company level. For example, despite a rocky year for China’s equity markets, investors in Chinese internet service or environmental service companies had a far more positive experience than the broader index. Given the array of reforms introduced after China’s Third Plenum announcements, rapidly changing consumer behaviors and dramatic shifts in industrial capacity growth, we see plenty of room for differentiated thematic opportunity within a broadly slowing economic backdrop. And China, while large and extremely influential, is still only a portion of the EM universe.
The shift away from convergent thematic drivers of EM growth will continue to present challenges. Those challenges are likely to generate worrisome headlines and may drive increased sector volatility and even some broad sell-offs like last year’s taper tantrum. However, we believe such volatility will create opportunities for patient, well-informed investors to benefit from the increasingly divergent outcomes across the diverse and constantly changing emerging world.