In 2018, the world economy – and global relations – entered unfamiliar territory, with rising geopolitical and policy risks. We are witnessing the global supply chains and trading relationships that have been integral to growing global prosperity come under increasing pressure.
Thus far, emerging markets appear to have borne the brunt of the fallout: an asymmetric – and, in our view, excessive – market reaction that has contributed to valuations at near crisis levels by November 2018. However, these are valuations that to us represent increasingly attractive buying opportunities, given where fundamentals stand.
What are markets anticipating?
There has been a substantial divergence in performance between emerging markets and US equities during 2018, on a scale that we find challenging to justify. While the US has benefited from the one-off, near-term impact of tax cuts and repatriation of overseas profits, this impact is expected to sharply fade in the coming two years, which is forecast to result in widening emerging market outperformance in terms of economic and earnings growth. The International Monetary Fund sees emerging market economic growth in 2019 holding steady at 4.7 per cent, while it has forecasted growth in advanced economies to slow from 2.4 per cent in 2018 to 2.1 per cent in 2019. Additionally, estimated emerging markets earnings growth of 10.5 per cent in 2019, while below projections of 15.4 per cent for 2018, would nonetheless compare favourably with estimated US earnings growth of 9.5 per cent for 2019, down from 21.2 per cent for 2018. On a forward-looking basis, we believe current fundamentals do not warrant the declines seen in emerging market assets over 2018. And while investor expectations may deteriorate, we think the gap between emerging market fundamentals and valuations is such as to provide a reasonably large margin for performance potential.
Trade tensions have been a primary contributor to weakness in emerging market equities, and while exports remain a key engine of growth for emerging markets, they are increasingly shipped to other emerging economies; the relative importance of developed markets has declined. Similarly, the roles of consumption and technology in generating economic growth have become more prominent; emerging markets have become more domestically orientated. While tariffs undoubtedly come at a challenging time for China as it seeks to deleverage its economy, the impact will also be felt globally – recent US corporate earnings announcements and concurrent equity market volatility are testaments to this. Politicians may yet conclude that trade wars are not easy to win.
Resilient to contagion and financial shocks
Sentiment on and performance by emerging market equities have also been impacted by the increased perception of crisis, driven by the much-publicised travails of smaller nations. We believe that weaknesses in markets such as Turkey and Argentina are unlikely to result in broader macroeconomic contagion, given the extent to which these countries have been outliers in terms of financing requirements and unorthodox policymaking, though the impact on sentiment has evidently resulted in a degree of equity market transmission. Moreover, these markets make up a small part of the emerging market and frontier market universe: within the MSCI Emerging Markets index, there were about 20 companies as of October 2018 that had individual weightings larger than Turkey’s as a whole; Argentina is even less consequential from an index standpoint.
US-dollar strength has been a further factor behind emerging market weakness over 2018. The near-term boost to US gross domestic product growth from tax cuts has placed upward pressure on interest rates, while repatriation as a result of regulatory change has increased demand for US dollar assets. Accordingly, while emerging markets earnings growth has been in double digits in local currency terms, it has been substantially weaker when US dollar-denominated.
While rising rates – by design –apply pressure to growth and inflation expectations, this is not solely restricted to emerging markets, and most debt ratios are considerably higher in the developed world. Emerging markets in aggregate have shifted to current account surpluses, floating exchange rates and a reduced reliance on US dollar debt funding. However, those emerging economies (and companies) pursuing less prudent policies have been punished heavily by financial markets. Investors appear to be increasingly discerning between winners and losers, which presents opportunities for active management.
Technology and rising affluence
The near-term challenges and poor sentiment toward emerging market assets have, in our view, obscured the longer-term picture, which is one of transformation as economies increasingly evolve away from dependence on exports, commodities and state-owned enterprises and toward more resilient sources of growth. Technology has become a primary driver of returns in emerging markets, whether manifested through world-leading semiconductor manufacturing, online gaming or internet banking, while e-commerce platforms facilitate rising consumerism. We retain confidence in the sustainable earnings power of many technology-orientated emerging markets companies despite some sharp share price corrections over 2018.
Consumption in emerging markets is not only a story of superior demographics and increased product penetration. Growing middle-class populations and increasing affluence should continue to drive “premiumisation,” spurring demand for high-end products in emerging markets. We believe companies with strong premium-brand positioning and superior products should see sustainable and higher-than-average industry growth levels in the years to come.
Never waste a crisis
Emerging market valuations have been approaching crisis levels due to substantially weakened confidence (and performance), yet cash flows and earnings generally remain resilient. These conditions, when paired with improving corporate governance that includes dividend payouts and buybacks, present an increasingly attractive long-term buying opportunity for us. Many currencies have been cheap, and as value-oriented, long-term investors, we continue to invest in companies that demonstrate sustainable earnings power and trade at a discount relative to their intrinsic value and other investments available in the market.
Chetan Sehgal is lead portfolio manager of Templeton Emerging Markets Investment Trust. The views expressed above are his own and should not be taken as investment advice.