Time for emerging nations to stand on their own

19 July 2016

It has certainly been a tough few years for emerging markets; and so far 2016 is continuing to pile on the pressure.

As a group we have seen marked underperformance of emerging market (EM) equities versus developed market counterparts in 2016, and most EM currencies have seen substantial devaluations against the US dollar. Local bond market performances have been mixed, as the relative attraction of high yields has battled with falling currencies and, in many cases, deteriorating macro- economic conditions.

Indeed, the whole proposition of grouping an eclectic mix of countries in a basket such as EM or even the BRICS (Brazil, Russia, India, China and South Africa) has been called into question in recent years. These baskets contain a multitude of countries with differing economic cycles, differing political cycles and, indeed, differing stages of development. We would also argue that these baskets make little sense from an investment perspective, other than convenience. Therefore, we believe that investors should start considering some of the larger EM countries as stand-alone investment propositions.

Despite this view, when looking at the performance of EMs more recently, particularly EM equity and currency markets, there has been a noticeable pick-up in performance versus developed markets in the wake of the brutal sell-off at the beginning of this year. If we look at the equities and currencies that have rallied hardest, again focusing on the larger EM economies, then the standout performers have been Russia and Brazil, with South Africa not far behind. The Asian EM giants of China and India have lagged.

 

So what factors have been behind these recent moves and are they sustainable over the coming months? We would argue that, in most instances, the positive returns are not due to improvements in underlying political and economic fundamentals, rather that there are two ‘big daddies’ in the room driving these movements: the United States Federal Reserve and China. The former is directly influencing most EMs as investors have swayed from hawkish to dovish over expectations on United States interest rates and, therefore, the outlook  for the US dollar. 

However, China remains, in our opinion, the single biggest factor influencing EM assets and will remain so for some time  to come. Ultimately, domestic politics and the growth slowdown currently underway in China will ensure that the country’s dominant exports will be deflation and volatility. The global impact of China’s growth slowdown was well explored in the last edition of Global Perspectives, but this is a trend which will continue to influence EMs for some time. 

So far this year a weakening US dollar and better economic data out of China have had a positive impact on EM. The rally in commodity and energy markets is a direct consequence of a weakening US dollar, and is also being driven by hopes for a demand-led recovery in China. Clearly many EM economies are reliant on energy and commodity production for a significant proportion of economic output.

However, China remains, in our opinion, the single biggest factor influencing EM assets and will remain so for some time  to come.

Therefore, rising prices (in combination with extremely bearish investor positioning in these areas) has led to commodity-and energy-related EM equities and currencies rallying hardest, while leaving the commodity consumers of Asia underperforming. Valuations of both the equity and currency markets of the commodity producing countries were in some instances getting cheap, particularly currencies. Ultimately, we believe that underlying fundamentals do not bode well for a more sustained trend shift, favouring broad-based EM outperformance. While the outlook for the US dollar is not as strong as we have experienced over the last couple of years - which should help EM assets - it is China that concerns us more.

The leadership in China is battling a major transition in its economy, trying to manage the process of a growth slowdown and refocus on services from manufacturing. While the current administration were  given early plaudits for their apparent reform zeal, there are signs aplenty that the slowdown in the economy, and the related impact on employment and social stability, are pushing Beijing back to the tried and tested plans of the past. In other words: an escalation of debt to achieve the political imperative of sustaining growth ahead of next year’s Party Congress. China’s reliance on credit injections to maintain growth is unsustainable, except in the short-term, and shows an absence of a clear economic strategy.

We would caution against the increasingly widespread view that a financial crisis is imminent due to China’s apparent high levels of debt. Most debt is issued by state-owned entities and local governments in local currency, and household and central government debt remains relatively low. Beijing still has immense resources at its disposal which should mean it will be some time before the debt situation becomes unsustainable. The trend slowdown in growth is, however, inevitable and ultimately the move away from a commodity intensive growth model to services means we are unlikely to see the start of a new bull market in commodities in the near future. That is great news for commodity consuming economies such as India, where we see little evidence of a risk of imported inflation.

That brings us to the final differentiator  in EM: reforms. Some governments have genuinely embraced reform and change in an attempt to revive economic growth. India leads the pack in this regard and, while growth on the sub-continent is yet to reflect a broad-based recovery, we remain extremely confident that the country is on the right path. Other larger EM governments are not on the same agenda, with Brazil, in particular, in the grips of a major political crisis.

Ultimately the outlook for EM remains mixed for the remainder of the year. Reduced headwinds from the US dollar should help, but China remains the main source of uncertainty. On the other hand the outlook for a country like India looks attractive. It is our belief, therefore, that investors will start to increasingly consider the major EM countries on their own merits.