Emerging markets roundtable: The discussion

8 Oct 2018

PI: Argentina’s economy never seems to be out of the headlines and Turkey’s has its specific problems, but now South Africa has gone into recession, which has surprised some people. Is that a sign that there is a deeper problem in emerging markets?

James Jackson: There is always going to be noise in emerging markets, whether it’s politics, trade or rising rates. For us, however, it is a strategic asset class that should be held long term. The long-term investment case is still intact with drivers such as favourable demographics, urbanisation and rising consumption remaining in place, which makes us think that it can out-perform over a full cycle.

Andrew Cheseldine: The point of investing in emerging markets is that as a long-term asset class it is expected to do better than more mature markets. You get diversification, including of currency, so why would you suddenly come out? The rationale for going into emerging markets has not changed. There might be specific countries that you want to avoid, so don’t be passive, but that’s about it.

Kathryn Langridge: I would largely agree with that. There is plenty of negativity about emerging markets at the moment. You mentioned Argentina and Turkey; they are largely architects of their own misfortunes. There are headwinds this year that emerging markets did not face last year, but growth, which is central to the long-term investment case, and earnings remain in place this year and into next year. More particularly, from an equity point-of-view, there are compelling opportunities at the stock level. That is where you are seeing genuine growth companies, often with innovative technologies and often large scale, able to take advantage of changing demographics.

PI: What conversations are you having with your investors about this turbulence?

Langridge: My investors are largely long-term and see through the short-term impact of some pretty large macro events that are inter-playing with local concerns in specific markets. But you cannot escape the fact that we are dealing with an environment of a stronger dollar and higher rates, which pose threats to the most vulnerable emerging markets, via liquidity strains and higher funding costs. So there are some big picture macro issues, but that will not derail the long-term investment case.

Ross Teverson: It is impossible for clients not to be concerned about what a stronger dollar means for emerging markets. There is also no getting away from concerns that what has happened in Turkey and Argentina may have some knock-on impact. It is true that most clients are long term. They appreciate that there is a structural case for the asset class that we have talked about. Generally speaking, fundamentals are more robust than they have been during previous periods of market weakness. Looking at standalone stocks and seeing, for example, that on aggregate earnings continued to grow at a double-digit rate during the first half and recognising that many emerging market companies have stronger balance sheets than their developed market peers is reassuring for long-term investors that there is still a good reason to be in emerging markets.

Jackson: The active management point is an important one. Argentina and Turkey have been mentioned. Argentina is not even in the emerging markets benchmark and Turkey is a very small component of it. These aren’t countries that you have to own. There is probably an assumption that all emerging markets are the same, but the reality is that they are a heterogeneous group of countries; and whether you want to cut them by valuation, growth or stage of development or any other measure. They are different, they are fragmented and there are opportunities within that for an active manager.

Langridge: The problem is that during this period of risk aversion, there is very little differentiation made between individual emerging markets. That is exactly the point at which an active manager can get interested because it is exposing some enormous opportunities that arise from a wave of risk aversion which is inappropriate at the company level and often market by market.

Teverson: Indiscriminate selling of stocks right across the markets because of a broader headline issue is something that creates opportunities for active managers to make long-term investments that will bear fruit.

Langridge: Collectively, emerging markets have strengthened their financial and economic resilience since the global financial crisis. Ross referred to the recovery in the structure of corporate EM, and those are the underlying principles here. What you do also have is a number of economies where pressure has become more evident with higher interest rates. That creates higher funding costs. So South Africa has its problems. Argentina and Turkey have problems. Brazil has problems. We are facing an uncertain election in Brazil and none of the principal candidates appear to be offering any clear solution to address the country’s profound fiscal problems. So there are a number of markets that have problems, but collectively emerging markets are in a much stronger position than they were five or six years ago.

PI: Are the demographics in emerging markets creating stronger companies?

Teverson: Absolutely. The demographics are quite remarkable in some frontier markets. Kenya and Nigeria, for example, have a median population age of around 20. If you can identify a strong company in a market which has that demographic tailwind, such as a strong banking franchise, then that creates an excellent long-term opportunity.

Stuart Trow: Where there is more of a contagion issue is in the debt markets. There’s no secondary liquidity because the nature of the credit markets has changed since the crisis. Basically, unless you are a first mover to get out of a position you are going to be stuck with it. There are some strong fundamentals in equities but fundamentally the debt equation, not just in emerging markets but globally, has changed. For all the volatility we have seen in emerging markets and certain other sectors, we have not seen much of a movement in US treasuries. They have had their quietest quarter for decades. We haven’t seen a panicked rush into gold either. Things have changed. Perhaps developed market equities are the new flight-to-quality – the Amazons, the Apples – because they have been growing fast at precisely the time when money has been coming off the table from emerging markets.

Cheseldine: One of the interesting things about the quality stocks just mentioned is that they sell an awful lot into emerging markets. So you are getting the emerging market exposure via a developed country.

PI: David, why is the National Union of Journalists Pension Scheme looking at gaining some emerging market exposure?

David Ayrton: Pension schemes, particularly defined benefit (DB) schemes, need growth and therefore we are forced to consider investing in emerging markets. But there are the concerns of volatility and of the unknown. I was talking with a fellow lay trustee yesterday and he said: “If we went into emerging markets now we might be zigging when we should be zagging, when before we were zagging when we should have been zigging.” In other words, is this the wrong time? The primary concern around that question is that we cannot see emerging market investments in isolation. We can only see it in relation to the developed markets. What a lot of lay people are looking at is the question of the protectionist stance that has been adopted by the US. At the moment, we see apparently surging markets in the US, so should this zig or zag be based now on more advanced markets, primarily the US. The associated concern with that, of course, is that if the US continues its protectionist stance is that going to be met with retaliatory tariff positions, particularly by China? The Chinese thus far have taken a cautious approach so as not to upset the US. As China finds its feet more as an economic and political power, is there a danger that we move into a trade war which could negatively impact the US?

Teverson: It is impossible for anybody to have visibility on when we are going to pass the peak of trade war concerns. It may be right now. There is an awful lot of negative news-flow around trade and protectionism. It is anyone’s guess as to whether that gets better or worse. What we can say is that there is a lot of concern around trade already reflected in asset prices. If you look at the price-to-earnings discount that emerging markets trade at relative to developed markets, it is as wide as it has been in the past decade. A lot is priced in already. Of course, there are plenty of scenarios we can envisage where trade fears begin to subside because a lot of what Trump’s doing is probably positioning ahead of mid-term elections. Policymakers, whether on the Chinese or the US side, realise that it is not in anyone’s interest to disrupt trade too much. We can see with Mexico that despite some quite radical things being said, it looks like there is just a slight tweaking of the relationship between the US and Mexico rather than a wholesale re-write.

Cheseldine: If you exclude China from emerging markets, what proportionate effect do trade wars have on the rest of emerging markets versus the rest of developed markets? It seems to me that the arguments Trump is picking are more with developed markets than with emerging markets. In theory, therefore, emerging markets could profit from Trump.

Teverson: A lot of emerging market companies are increasingly generating revenue from within emerging markets. So you are seeing greater intra-regional trade. It is quite hard to quantify the secondary effects of US protectionism and how that impacts consumer confidence and capital flows. It is hard to come to a conclusion as to whether emerging or developed markets are more vulnerable.

Langridge: What you are also going to see are more diversified supply chains, not just centred in China. It’s important to understand that there has been a substantial shift, certainly among major emerging economies, to rebalance away from export dependency and create self-sustaining drivers of domestic growth. In China, for example, 52% of GDP is now derived from domestic drivers of growth. That is a major shift over the past 15 years or so.

Jackson: If you look at the direct impact of trade on listed companies in China, there’s actually a low proportion of their revenue coming from the US. It is about 1% to 2%, compared to around 20% for Europe.

Langridge: Two-thirds of the top 25 exporters in China are multi-nationals and most of those are US companies. So, as Ross described, there are complex secondary effects that are concealed beneath the trade war headline.

Teverson: It is fair to say that China is moving in the right direction in terms of unfair trade practices. So it is conceivable that Trump can declare a victory in that some things have improved and we can move on.

Langridge: Another aspect of this is that Chinese companies as a result will also be working to improve their competitiveness through increased automation and moving up the value added supply chain, for example. There are many responses to trade wars that actually can have positive long-term effects.

PI: We hear a lot about the high levels of debt that Chinese companies are carrying, is that why you don’t invest in Chinese banks, Ross?

Teverson: Levels of debt in China are high and it is difficult to have good visibility on true asset quality of these banks. Chinese banks appear to be attractively valued, so there is some concern in the price, but it is that visibility on asset quality that concerns us. Having said that, China is beginning to do some of the right things to address the systemic risks that are arising from such high levels of debt. The jury’s still out as to whether China grows out of those debt problems gradually or whether we have to go through an episode where there is some adjustment.

Trow: Chinese banks have been cheap for a long time, so it’s almost more a case of the Chinese market as a whole is moving towards the banks, rather than the other way round in the past 12 to 18 months.

Teverson: Part of the reason valuations are low is because not only are there asset quality risks that could eat away at earnings in the coming years, there is also the risk of net interest margins compressing as well. So even if over time deposits and loans continue to grow, there may be relatively short earnings growth in those banks with the dual pressures of asset quality and margin.

Trow: It’s not completely dissimilar to the European banks. I’m not suggesting it’s exactly the same, but European banks are struggling in terms of profitability and momentum. It is difficult to see where they generate profits and it is the same for the Chinese banks. That is the one area where the lack of transparency and visibility is a real problem. If you have a problem in your financial sector, that always leaves an element of doubt. One of the things that’s striking since the financial crisis, is that if you look at global stocks, they massively out-performed emerging markets, but the one region that’s moved in parallel with emerging markets has largely been Europe. So both of them, for a long time, have been the next thing to happen and neither of them has actually caught fire.

PI: Transparency is a big issue. How would you describe the level of governance in emerging markets?

Trow: It varies from market to market. Again, you look at Chinese GDP numbers, they come out on the button every quarter and they don’t look credible because there’s no volatility in them. If they don’t look credible it makes you wonder what is behind them. Maybe I’m being over-sceptical about that, but then you have Turkey where the economic bureau has quite a good reputation and people are slightly fearful that maybe political pressures might alter that. As things are at the moment, they seem quite open and transparent, relatively speaking.

PI: When you are doing your research, is there much independently-audited data that you can turn to?

Langridge: The key to successful emerging markets investing from an equity perspective is knowing your company from the inside out and doing your homework. You can identify through qualitative and quantitative analysis good quality companies with high returns on capital, with reasonable environmental, social and governance standards. The data is there. Often you need to be quite shrewd as to how you assess that data, but in broad terms, transparency across emerging markets has improved dramatically from the early days of my career in the 1980s where you had to roll your sleeves up and ask questions yourself because the data wasn’t there. One of the turning points in terms of improvements in governance, transparency and disclosure came post the Asian financial crisis, when it became clear that the best quality companies were going to be able to attract capital and the worst were not. You have to conform to high international standards and corporate governance to attract capital. So that was something of an inflection point.

PI: If you come across a company where you are concerned about its transparency, would that put you off investing or would you work with management to improve standards?

Langridge: If I can’t build conviction about the integrity of the company in which I’m contemplating  investing, I won’t invest. Where there are red flags, you investigate them until you can build that degree of conviction. It is important to understand where there is an alignment of shareholder interest. It is vital to invest in companies that act with integrity, and where as a minority shareholder, your interests are not going to be compromised. Investing in emerging markets does bring additional risks, but those risks are not insurmountable. A good quality investor is going to ensure that those risks are moderated to the extent that it’s possible to do so.

Jackson: Within emerging markets it’s interesting that governance and ESG is not something that managers are doing because it’s currently popular. It is something that they have done for a long time because it clearly adds value. We are doing work on China A-shares at the moment, and as a proxy, if you look at the difference between state-owned versus privately-held companies, there is a vast level of outperformance from 5% to 10% p.a. over the last five years.

Teverson: Part of the reason there has been a big improvement is because active managers have been putting pressure on companies for a long time to improve transparency. To the point that Kathryn made about management alignment, we do see more companies recognising that management needs to be incentivised with long term equity-based compensation rather than being set key performance indicators like revenue growth that may not have anything to do with creating value for shareholders. Taiwan has come a particularly long way. When I went there for the first time in 2000, companies were giving away free bonus shares to employees, which if they had been properly accounted for would have completely wiped out a whole year’s net income. The picture today is completely different. Accounting standards are much stricter in Taiwan, in line with international standards. The Taiwan Stock Exchange comes to London to meet investors to get advice as to what they can do to improve governance standards. To be honest, there is not a huge amount of advice they need because the standards in Taiwan are now pretty much up there with the best developed market standards. Korea has more challenges, but even with Samsung Electronics, where in the past people have been quite concerned about governance, what you see there now is a clear shareholder return policy. You can see a route to some of that large cash pile sitting on its balance sheet gradually being returned to shareholders. So there have been improvements.

Langridge: In general, across emerging markets accounting standards have improved. In most cases they conform to global standards.

Trow: What you are seeing is that the corporates are putting pressure on governments to tidy up their acts.

Langridge: They recognise that it’s to their advantage. Their cost of capital will be reduced.

Cheseldine: It is also to their advantage, of course, because if you are doing things right and your competitor down the road isn’t, you have a short-term advantage.

Ayrton: We have certain standards because we want relative surety for our investors when colleagues are managing funds. Is there a danger that we could miss opportunities by being too stringent in terms of transparency when new markets open. For example, infrastructure development through China’s Belt and Road initiative? What are the advantages of diversifying a little bit from our stringency on transparency?

Langridge: The disadvantage is that you lose your investment. So it’s absolutely vital to do your homework to understand that there is an alignment of interest between the majority and minority shareholders. Then you can go wherever you can find companies that conform to good investment criteria. The Belt and Road initiative will undoubtedly open up new investment opportunities in some of the frontier markets, but unless you have high confidence in the quality of the business that you are investing in you are not acting in the best interest of your stakeholders.

Teverson: There are some well run businesses in what are challenging markets from a political and economic risk perspective. Sometimes those can be the highest return opportunities. So in Pakistan, which is probably the most significant beneficiary of the type of investment you are talking about, if you have the right management team then there’s certainly an opportunity from that Chinese investment. Likewise from a number of African countries that are starting to benefit from this Chinese commitment.

Langridge: What that points to is the range of investment opportunity, and that comes back to the original investment case for emerging markets, which is based around growth opportunities in new parts of the world that investors are not fully aware of. That is our job, as emerging markets specialists, to identify those opportunities.

PI: What opportunities has current volatility created in terms of sectors?

Teverson: Some of the most compelling opportunities from a valuation perspective are in IT hardware, particularly semi-conductors. You have companies that historically operated in a competitive, cyclical business, and there’s still some cyclicality there, but that has been massively reduced by memory chip production becoming an oligopoly. If you look at valuations of those companies, they are being valued as though they are still deeply cyclical. As I mentioned earlier, Samsung has a cash pile. That cash pile is equal to 30% of its market cap and it is trading on a mid-single digit multiple at a time when the dividend is rising. So there are definitely opportunities within IT hardware to invest in companies that offer significant future returns.

Langridge: The interesting aspect about those companies is that they represent a new source of global corporate leadership. They have differentiated technology, leadership and scale and are key parts of a global supply chain which has emerged in the past 20 years.

Trow: One of the problems for emerging markets in general, which makes it difficult to pick opportunities, is that the whole game has changed. It seems like we haven’t got a safety net anymore. In crises in the late 1990s, the IMF could always be prevailed upon to come with a new unprecedented “whatever-ittakes” type policy.

Next time around I’m not sure that will be possible. So if somebody gets in trouble, they are going to stay in trouble. It is going to be difficult to dig themselves out. You might get a situation, certainly from a debt perspective, where you don’t sell what is distressed; you sell what you can, as we saw during the financial crisis. That is how contagion could spread to areas where it really shouldn’t be, but it’s more of a liquidity issue.

When there were problems in Malaysia, Thailand and Mexico in the past, the IMF broke its rules to deliver a package that was big enough to be convincing. I’m not sure that, with a Trump presidency, anybody’s going to be brave enough to try and sell that to sceptical US politicians.

Certainly Trump does not have the statesmanship to say: “Look, this is what we need to do. This needs to get done.” Arguably, you could say that Argentina was a bit of that because we have a package on the table, but it certainly isn’t a decisive package. For the last few decades, we have been in a position where what has always been required is a decisive package, whether it’s the eurozone sovereign crisis, the global financial crisis or the smatterings of emerging market crises we have had.

Cheseldine: It’s not just Trump because Europe has its own problems. How are they going to cope without the UK and its income? I cannot see the European Central Bank rushing to bail out Greece if it went wrong again. Trow: And Europe, for all its wealth and power, geopolitically punches below its weight, which is not helpful for trying to sort out ancillary problems for Turkey, for example. The EU, being the local domestic power, you would have hoped that it would engage a bit more constructively with Turkey, and that’s not really happened.

Ayrton: This Turkey question, is it primarily a political question in relation to the Turks’ relationship with the United States? If that is the case, are we not in a position where the Chinese and therefore the broader emerging markets can take advantage of the US and the EU’s failure to accommodate the Turks and other parts of the world in a similar way?

Langridge: There’s no doubt from a geopolitical perspective that the Chinese will be playing a powerful hand and will be making new alliances as a result of perceived weaknesses, however engendered. In terms of Turkey’s economic problems, they are architects of their own downfall. They have persistently stimulated the economy through rapid credit growth. They have twin deficits, both fiscal and current account, fuelled by external borrowing and short-term capital flows. That has been aggravated by a policy response in which President Erdogan has undermined the credibility of the central bank. He’s gone for growth and allowed inflation, which has resulted in the currency collapsing. That sharp depreciation and huge foreign exchange indebtedness further aggravates banking problems and may drive the country into recession.

Trow: To some extent they have been victims of their prior success. A lot of the hard currency borrowing, particularly in dollars, has been because it’s cheaper to raise foreign currency borrowing than it is to borrow at home. So it’s not necessarily that people need hard currency funding, it’s that that’s the cheapest way of doing it. Now that the credibility of the Turkish authorities has been diminished, they are left in a situation where access to refinance their hard currency borrowings is just not there. The whole thing only staggered on for as long as it did because people had faith in the Turkish capital markets. They have quite well developed capital markets, but it’s taken a lot to drag them down to the level that they are now.

Cheseldine: If China is buying influence by lending cheap money, and we have already accepted that China is massively indebted, where is it going to get the money to lend at a cheap rate to Turkey or somewhere else in the longer term? Historically, it’s been the US. It is difficult to see how people are going to lend at 5% to China so that China can lend cheaper somewhere else. It doesn’t make sense.

Teverson: On quite a few of these investments that China is making, their overall long-term return will be quite good, actually. You may hear of a Chinese development bank offering loans at 3% and 4% to build infrastructure, but Chinese contractors are involved. The long-term returns on some of those infrastructure projects will be high and the Chinese will be taking a part of that return. So they are perhaps more rational allocators of capital to overseas projects than people think.

PI: Going back to the stock level. Are emerging markets just about technology companies and commodities?

Teverson: Commodities have become much less important to emerging markets. That is a change that perhaps isn’t recognised enough. There are some interesting sectors developing. Healthcare, for example, is a tiny part of the emerging market index, so if you went via the passive route you would get little exposure to healthcare. But from a stock pickers perspective there are a number of opportunities, whether it be in hospitals or in emerging pharmaceutical names. Companies on the pharmaceutical side benefit from a relatively low cost base and a domestic market that is growing much faster than domestic markets are in developed countries. Healthcare is going to become increasingly relevant within emerging markets.

Cheseldine: I always worry how much of it is ‘chicken and egg’ in that a lot of countries with substantial commodity resources are the ones with the most political volatility. Venezuela has lots of commodities, but I don’t see anyone jumping to invest there at the moment.

Teverson: It’s a sad fact that there is almost an inverse correlation between the amount of commodities that a country is able to produce and their level of governance. The less resource rich a country is the better its economic institutions are. We have seen that time and time again.

Jackson: There remains a perception that emerging markets are a commodity play, but that has changed over the last 10 to 15 years. It is no longer about fixed asset investment and export from China, and that has manifested itself within the index. Five or six years ago, energy and commodities were around 30% of the index, now it is down to around 15%. In its place has come information technology, which is up to about 27%.

Trow: Going back to what Ross was saying, healthcare is the ideal way of leveraging a move to a middle class. A lot of commodity countries are going the other way, exporting their middle classes either downwards or outwards.

Langridge: It’s not just healthcare. There are many other aspects of consumer spending that represent growth opportunities in, for example, leisure, tourism, education, the development of new brands, and, of course, savings products. So there are many potentially highly lucrative areas that will develop rapidly with the growth of an affluent middle class and new consumer habits.

PI: Russia is in the headlines again. What would more sanctions on Russia mean for markets?

Langridge: The key vulnerability for Russia at this point is more sanctions, although it’s quite hard to see what more powerful sanctions could be levied. One possibility could be newly issued state debt. Russia is always a cheap market, and it’s cheap at the moment because of sanctions. If you were to put sanctions to one side, Russia has a current account surplus and inflation is low. Policy in Russia has been moderate, targeting low inflation and fiscal constraint. So at a macro level, Russia is actually doing many of the right things and because of sanctions Russia has become more resilient to global conditions and more dependent on their own domestic drivers of growth. The best quality companies in Russia have improved shareholder-centric governance than they had in the past when it was pitifully poor. There are a selective number of good companies in Russia that are generating high levels of free cash-flow, are reinvesting in their future growth and returning cash to shareholders. It is not all bleak in Russia, but there are huge problems and I certainly wouldn’t give the country a blanket seal of approval. You have got to be highly specific. You have got to know what you are investing in.

Trow: The other positive for Russia is that there’s not been a political will internationally to make sanctions tough enough to not be able to be circumvented. When we had the last round of sanctions earlier in the year, I thought: “Wow, that’s a big deal.” Actually, they changed ownership structures to move away from the particular named oligarchs and things recovered pretty rapidly.

Teverson: With those sanctions, it quickly became apparent that if you stop foreign investors from owning shares in a certain company then the people you hurt the most are the foreign investors that then dump their stock and it gets bought up cheaply by Chinese and Russian investors. So if you look at what is currently being suggested in terms of potential sanctions, there doesn’t appear to be anything of that nature being discussed, yet what is reflected in share prices is a fear that there will be something that is materially negative for holders of Sberbank’s equity, for example. Going back to the observations we made on trade, it is hard to say exactly how that will pan out, but what we do know is a lot of concerns are already priced into stocks and that is true of this sanctions risk, as well.

PI: Volatility is high and companies are stronger than they were, so what is your outlook for emerging markets?

Langridge: There is a strong long-term investment case to be made about emerging markets, but for now there are global challenges that have to be worked through. We have moved from a period of extreme euphoria to extreme negativity. That is the point at which your interest in the long-term investment case for emerging markets ought to be raised, given the opportunity to gain exposure to industry leading companies that will generate strong returns at an opportune entry price. The long-term investment case is intact, but short term there are challenges that will be worked through.

Cheseldine: The strategic asset allocation case is still there, as it has been for a number of years. A long-term investment makes a lot of sense.

Trow: At the same time, the global macro overlay is that there is going to be less and less liquidity with central banks taking money off the table. On a net basis they are going to be reducing balance sheets, probably from the middle of next year and the European Central Bank is probably stopping later this year. That is going to have a major impact. We saw earlier in the year with the volatility trades where people were unable to get out of positions, and they were structured around ETFs. I’m not saying ETFs are inherently dangerous, but with emerging market debt, for example, ETFs imply a liquidity that’s really not there. These stories could run further than the fundamental analysis suggests. That’s what concerns me.

Ayrton: During the swing from euphoria to negativity, is there an opportunity for investors to move in and buy at cheap prices as panic selling takes place?

Langridge: That’s exactly the phase we are moving into. It is impossible to know how long this opportunity will persist for because there are considerable problems to work through. So we are not trying to call a bottom to emerging markets. We are saying there is an interesting entry opportunity.

Teverson: One of the key things to come out of this conversation is that while in the press emerging markets are often talked about as a collective group of investments that should move in the same direction, if you look at the underlying fundamentals, there are some huge differences across that emerging market universe. When you see indiscriminate selling across the asset class, it has to create opportunities in individual companies that are very strong.

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