Conrad Saldanha focuses on the macro backdrop and positive political reforms in his analysis of global emerging markets.
Emerging markets often find themselves at the mercy of investor flows and sentiment. After rising some 15% since the end of December, the MSCI Emerging Markets Index has given about half of that back in May, as the tone in trade talks between the US and China has grown darker.
However, understanding what is going on in emerging markets means contrasting the short-term news cycle with the business cycle, as well as with the medium-term electoral cycle and the long-term megacycle that the emerging world has been in since the late 1990s.
Improving the macro backdrop
This megacycle has seen widespread integration of emerging markets into the global trading system, most notably with China entering the World Trade Organization in 2001.
Subsequently, there has been an evolution in the constituent industries of these countries, moving from commodity production and lower-value manufacturing to technology and services. This has not only increased the sophistication, the return on equity, and the earnings growth prospects of emerging markets, but also increased the domestic focus and heterogeneity.
There has also been broad adoption of orthodox economic and fiscal policies, including inflation targeting, by independent central banks, which has lowered inflation and compressed risk premia in government bond markets over time.
A general move towards more local currency and longer-term financing, a build-up of foreign-exchange reserves, and more balanced current accounts have made sovereigns a more stable foundation for domestic industries and corporations.
Emerging market companies increasingly compete against global peers and work with institutional investors, such as Neuberger Berman, who actively engage to help improve disclosure and optimise capital allocation to the benefit of all shareholders.
This has resulted in an increasing number making improvements not only in terms of operations, but also in corporate governance. Nonetheless, selectivity is key, given the heterogeneity.
Positive political reforms
In terms of the political cycle, we are beginning to see the first generation of pro-reform administrations consolidate their positions or cede to similarly reformist leaders.
Joko Widodo won a second term as president of Indonesia recently. Brazil is pressing on with much-needed economic reform under President Jair Bolsonaro and his finance minister Paulo Guedes. And perhaps most significantly, Narendra Modi won a second term as prime minister in India. During Modi’s first term, India implemented a national goods and services tax, while also improving corporate bankruptcy laws – both should boost the economy over time.
This is not the case everywhere – President Mauricio Macri is polling badly in Argentina, and Turkey is an example of how economic orthodoxy can slip as political dominance grows.
But these countries are more significant for emerging market debt than equity investors. Divergence across emerging markets on this issue only reinforces the argument for an active approach to country allocation.
Emerging markets in full mid-cycle swing
Turning to the business cycle, while the US economy and equity market both show signs of being late in the cycle, emerging markets generally appear to still be mid-cycle. The MSCI Emerging Markets Index price-to-earnings ratio of 12x compares favourably with the S&P 500 Index ratio of 17x and the MSCI World Index of global developed markets at 16x.
Moreover, current valuations are not late-cycle valuations, and the growing technology component in emerging markets should imply slightly higher multiples than in the past. Neither are emerging market fundamentals showing signs of late-cycle fatigue.
Whereas corporate earnings have raced ahead of GDP growth in many developed economies, they still lag GDP growth in many emerging economies. India is a notable example, where 2017 earnings shrank by 0.9% even as GDP grew by 6.7%.
Corporate leverage has also been declining much more rapidly than it has among developed market companies. According to Bank of America Merrill Lynch Global Research and evidence from company reports, whereas global emerging markets and US companies’ net debt-to-EBITDA had risen to about 2.5x by the end of 2015, since then US corporate debt has plateaued, while in emerging markets it has declined to about 1.5x. This helps to explain why the default rate surprised to the downside during 2018.
There is no doubt that uncertainty around trade policy, an uneven recovery in China and Europe, and the stubborn refusal of the US dollar to reverse its year-long rally have all been weighing on investor sentiment recently.
However, should some of the heat die down in the US-China dispute, we believe that this would lend support for the incipient recovery in China and other emerging markets to solidify in the second half of 2019.
Along with the Federal Reserve’s recent dovish turn, this can help focus investor attention back on to the attractive, mid-cycle fundamentals and valuations evident across selective segments of the emerging equity market.
Conrad Saldanha is senior portfolio manager, emerging markets equity, at Neuberger Berman.