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Chinese equity rally can continue

Not all emerging markets are created equal

22-10-2015 | Insight | Fabiana Fedeli Emerging markets have been battered indiscriminately these past months. Now that the baby has been thrown out with the bathwater, it’s time to pick those stocks that have been unfairly hit and that can outperform in the medium to long term.

Speed read:
  • The baby has been thrown out with the bathwater 
  • This creates opportunities for selective investment 
  • Strong reform stories are China (yes, China), India and Korea
A perfect storm
In emerging markets, all negative events that could have happened, happened. The looming prospect of the Fed hiking rates – eventually – has been putting pressure on emerging currencies. The Chinese government’s decision to move to a more market-determined exchange rate for the yuan, although much-needed, was very poorly timed, and on top of that Chinese domestic shares have been faced with great volatility. The earnings season for emerging markets has been disappointing. Outflows from emerging markets amount to a cool USD 63 billion year to date  and are at the levels of annus horribilis 2008 (source: Bank of America Merrill Lynch, The Flow Show, 8 October 2015).

The result: since its most recent peak in April of this year, the MSCI Emerging Markets index has plummeted by almost 20%. The interesting part is that markets make little differentiation among the various countries – they never do when they’re in panic. Since June 30, 2015, 99.6% of the MSCI Emerging Markets index has underperformed Europe and the US.

‘Now is the time to start selectively looking for opportunities’

However, emerging markets are not one homogeneous investment category. They are spread across various continents, are in different stages of development, have other drivers and face highly diverse political conditions. There’s a huge difference between a country like Brazil, which is faced with a deteriorating macro-economic, fiscal and political situation, and India, where macro-economic figures are improving and Modi is implementing much-needed reforms. This creates investment opportunities.

It’s commodities that are causing the pain
When we look at the fundamental drivers of the pain, we see that these are mainly related to the slump in commodity prices. The decline in commodity prices had a negative impact on some but not all emerging markets. The commodity exporters were most vulnerable: it’s their currencies that were the most hit and their earnings that declined.

As Figure 1 shows, the lower oil price is, on balance, a positive factor for emerging markets, benefiting some 80% of the MSCI Emerging Markets index’s market capitalization.

Figure 1. Winners and losers of the low oil price
winners-and-losers-of-the-low-oil-price.jpg 
Source: Deutsche Bank, IMF, as of December 31, 2014

When looking at currency pressure and earnings per share, we see a clear difference between manufacturing emerging markets and commodity emerging markets. This is shown in Figure 2.

Figure 2. Manufacturing versus commodity EMs: currencies and earnings
FX index against USD (Rebased, Jan 2010 = 100)            12M Forward EPS
Not all emerging markets are created equalNot all emerging markets are created equal
Source: Bloomberg, as of September 30, 2015

The impact of a possible Fed hike also varies
The impact of the Fed’s policy also varies strongly across emerging markets. Emerging market equities do not necessarily drop when the Fed hikes rates. They drop when the outlook for growth is poor. From 2004 to 2008, for example, a period of tightening Fed policy, emerging markets thrived. The countries that will get hit by a Fed hike, are mostly those with a USD-denominated debt and a large current account deficit.

Buying opportunities
After such as a deep fall, at some point the market is set to rebound, and we have seen that happen in the last couple of weeks. When that happens, all stocks rise as indiscriminately as when they fell. However, it is key to look for sustainable medium- to long-term earnings growth. This can be found in several countries, but the strong structural reform stories that stand out are China, South Korea and India.

China
China is undergoing a structural transformation. An ambitious reform plan is on the way, providing, among other things, more freedom for private investments, reforms of state-owned enterprises and market pricing of resources and the environment. Currently there are two Chinas. One the one hand, there is the ‘old’, manufacturing China, which is dealing with overcapacity, and on the other there’s the China of the services industry, which is growing steadily as a part of GDP. Consumption is also holding up rather well. When looking for investment opportunities, it’s therefore important to look in the right places.

Currently, China is underrepresented in market indices. If A-shares and ADRs were fully included, China would account for more than 40% of the MSCI Emerging Markets index, versus the current weight of close to 23%. Add to this a valuation that is at all-time lows and there are plenty of opportunities for the discerning eye.

South Korea
Large Korean companies are cash-rich and are showing the first signs of improving shareholder friendliness, for example by increasing their payout ratios or buying back shares. The payout ratio is currently still at the bottom of developed and emerging markets, but in December 2014, the government passed a law to either invest or pay out retained earnings. We expect the ‘Korea discount’ to tighten.

India
In India, the Modi-led government has implemented a commendable list of reforms, and more is yet to come. The red tape that has traditionally been an important obstacle to capital investment has been significantly reduced. Private sectors have been opened up further to foreign investments. The Insurance Bill, for example, has increased the foreign direct investment (FDI) limit from 26% to 49%. The railways FDI limit has even been increased to 100%. The infrastructure budget has been increased substantially and with programs like ‘Make in India’ and ‘Digital India’ we would expect job creation to accellerate.

On the back of these reforms and also helped by a benign inflationary environment and lower interest rates, the capital spending cycle in India has been recovering since mid-2014. Of course some important reforms still remain to be completed, of which the Goods & Services Tax is the most important. That said, we expect more progress at this end in the coming year.

Conclusion
There are many compelling investment opportunities in emerging markets, as long as you look in the right places. The times when everything remotely related to emerging markets went up, are over. Now is the time to do your homework, and thoroughly research which pockets of which market are interesting, and which ones you should steer clear of. For the discerning investor, emerging markets can therefore offer vary attractive returns for years to come.


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