Investors are now at least querying the thesis that superior long-term growth – combined with improved governance – would lead to sustained outperformance by emerging market assets. At worst, they fear a repeat of the collapse in emerging market economies, currencies and investment markets of the late 1990s.
However, the importance of emerging market assets to global markets has grown significantly: there are now some 7,000 investable companies; the total market valuation is about $4trn – about 32 per cent of the global equities total; the investable universe for emerging market debt has grown to over $13trn; and finally, emerging market government debt is set to double over the next 10 years, reaching 20 per cent of the sovereign debt universe. Investors make the mistake of aggregating emerging economies together as if they were all similar. While there are common characteristics, there are radical differences in the stages of development these countries have reached, their dependence on resource extraction or production, the importance of trade, the size of their populations and their demographics, their growth rates, their external indebtedness and their political stability.
Divergent investment performance is inevitable. What most emerging markets have in common is a reliance on foreign capital due to inadequate domestic savings but, even here, there are exceptions.
For active investors, this divergence is not a problem but a huge opportunity. Investors in sovereign debt can add value from the currencies and bonds of 70 disparate countries, also adding value from duration, inflation-indexed and dollar debt as well.
Corporate bonds add a huge new dimension, based on the credit worthiness of borrowers. In equity markets too, the opportunity is primarily from bottom-up stock-by-stock analysis rather than top-down country, regional or global allocation.
For example, sovereign debt benchmarks are weighted by the issuance of each country, yet the degree of indebtedness of a country can be a poor guide to its investment attraction, though the most widely used indices use caps of 10 per cent for each country, however large.
Nearly 25 per cent of the MSCI Emerging Market equity universe is accounted for by government-controlled or influenced companies, which are often unconcerned about generating returns for foreign investors. More than 7 per cent of the benchmark is accounted for by Chinese financials alone.
Seven countries (Brazil, Russia, India, China, South Africa Taiwan and Korea) account for nearly 80 per cent of the index, which is heavily weighted to resources, financials and telecoms. Consumer goods and services, such as healthcare, are very under-represented, yet domestic consumption is surely the sole end and purpose of all economic development.
Performance of indices over 3yrs
Source: FE Analytics
Despite the weak index performance, many emerging market companies have done well. Until the recent sell-off, mid and small cap companies were significantly outperforming in all regions.
Consumer-focused companies have also outperformed while companies controlled or influenced by governments have generally done poorly. Most importantly, companies that generated cashflow and returned it to shareholders via dividends and buy-backs have significantly outperformed.
This points to one of the key reasons why emerging market equities have performed poorly in recent years: companies have over-invested in growth rather than generated free cashflow for the benefit of shareholders. A reasonable balance between investing for growth and cash returns for shareholders is demanded by most investors.
Arguably, developed market companies have underinvested in recent years, under pressure from investors demanding cash returns. By contrast, emerging market companies have, on average, higher reinvestment rates than developed market companies, restricting free cashflow.
According to UBS, this is set to change, forecasting a jump in free cashflow yields for emerging market companies this year, converging with those in developed markets. Return on invested capital is also expected to rise.
What does this mean for investors?
In the short-term, emerging markets could continue to be difficult. Although some currencies now look undervalued, others, notably the Brazilian real and Chinese renminbi, do not.
Currency weakness threatens higher inflation, higher interest rates and lower growth. Governments have sought to placate popular unrest rather than accelerate the reforms that should overcome the obstacles to growth. A replay of the late 1990s crisis looks extremely unlikely, but the pain may not be over yet.
That does not mean that emerging market equities or debt should be avoided, given the opportunity for adding value from stock and credit selection. In equities, the recent sell-off has made quality companies look cheap. Being a selective early buyer, but being prepared to be patient, makes sense.
Finally, the distinction between emerging and developed economies and markets is beginning to blur. Some emerging economies, such as Korea, deserve to be regarded as developed, while some developed economies, such as Greece, threaten to sink back. Many emerging market companies are listed on developed market exchanges while many developed market companies have significant sales in emerging economies.
Without sustained growth in emerging economies, growth will be a challenge for developed economies and companies based there. Behavioural and governance differences between emerging market and developed market companies are likely to decline; emerging market governments should stimulate domestically financed investment as the best route to sustained growth.
We believe emerging markets are suffering a cyclical, not a secular, bear market.
Max King is a strategist at Investec Asset Management. The views expressed here are his own.