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James Donald: Why the emerging markets rally will gather steam

29 July 2014

James Donald, manager of the £770m Lazard Emerging Markets fund, tells FE Trustnet why investors can now afford to be bullish on emerging market equities.

By James Donald,


There is a sense among many equity investors that even if global economic indicators are not back to full health, at a minimum, economies have not regressed. ALT_TAG

This firmer footing appears to be helping investors to refocus on stock fundamentals. Although US taper fears have largely subsided – aided by convincing policy responses by many emerging countries and signs of improving deficits – the path of US interest rate movements remains important to the performance of emerging equities.

We believe that emerging markets investors have largely priced in a scenario of a gradual rise in rates. However, should US rates rise rapidly or do so sooner than expected, emerging stocks could suffer, similar to the end of 2013, when the US Federal Reserve first announced its taper intentions.

For emerging markets stocks, we find the current low-growth environment ideal as it allows this group of economies to gradually absorb benefits, with less risk of the counterproductive inflation typical of rapid growth.

At the beginning of 2013, we posited that emerging markets equities would outperform developed stocks in a slow-and-steady growth environment with no major external shocks. These conditions prevailed in the second quarter, and our thesis has held.

Performance of indices in 2014


Source: FE Analytics

We have ruled out the scenario of a global depression, in view of economic progress worldwide, including the United States.

For most developing countries, high growth rates are not necessary to maintain strong stock performance as these countries have fairly low economic hurdles in view of their modest debt and unemployment levels, as well as low interest rates.

Fast growth in an economy with low unemployment will most likely result in undesirable wage inflation, whereas, it should be relatively more beneficial to developed-market economies with higher debt and joblessness, such as Japan and in Europe.

Through this lens, China’s 7.5 per cent growth estimate for 2014, while low compared to years past, still appears reasonable to us, although we would be concerned about any large downside revisions.

China’s sovereign debt levels are by no means among the world’s highest. They are on par with the emerging region’s average and below that of most developed countries. However, China’s growth rate still exceeds that of any other country in the world, except India.

That being said, slackening demand from China will be felt by the rest of the emerging region, but this should be largely offset by growth elsewhere in the world. Europe and Japan have accelerated slightly this year, and US growth appears to be on the right path following a harsh winter.

From our perspective, today’s risk to Chinese growth is the increased leverage in China’s financial system.

Historically, directed lending in China has favoured state-run entities, which has motivated credit-hungry private-sector companies to seek alternative financing.

Local authorities have also increasingly relied on leverage in order to fund spending as, unlike the central government, they do not have a direct claim on tax revenues. Separately, the private sector has found an audience in investors seeking returns outside low deposit rates and the local property market, which has contributed to the growth of informal lending in China.

At the end of 2013, about 30 per cent of Chinese GDP, or 18 trillion yuan stemmed from informal lending between 2009 and 2013, growth in informal loans far outpaced that of the overall credit sector.

The systemic risk surrounding the rapid rise of informal lending, and perhaps more to the point, its risk of failure, is forcing the new leadership to perform the delicate balancing act of containing its spread without dampening economic growth.

We would be surprised not to hear more news of nonperforming loans in China, but we believe that this will occur in a relatively controlled manner.

While the central government may act as a backstop for some loans, and could even set up liquidity facilities similar to those recently seen in developed countries, we believe that it will allow failures to occur. This will send a clear message about Beijing’s low tolerance for fiscal irresponsibility.

Some local governments have very recently been given the option to sell assets in order to offset debt. Monetizing stakes in state-owned enterprises [SOE] has become possible due to President Xi Jinping’s focus on SOE reform.

All things considered, a full-blown financial crisis in China is unlikely, in our view.

Although its credit challenges may invite comparisons to the recent credit crisis in the developed world, there are at least three crucial differences: First, China has a closed capital account. This removes the risk of capital flight, which has been the undoing of troubled market economies in the past.

Second, China has amassed two-thirds of the world’s foreign reserves, which provides an extremely thick financial cushion should it need to pour money back into its economy.

Third, China has a centrally planned economy and the state is able to intervene directly and powerfully in capital reallocation and financial reform.

It is important to acknowledge China’s challenges as context for investing. However, it is just as important to us to distinguish this from a Chinese company’s ability to thrive. Many of our investment teams across disciplines, including relative value, relative growth, and core equity, have meaningful positions in China and have been selectively adding to these holdings over the past several years.

Chinese stocks have historically been expensive, reaching a high of about 32 times trailing earnings in October 2007 but, as of this June-end, this multiple declined to about 9.8 times trailing earnings.

Performance of indices over 3yrs


Source: FE Analytics

Misplaced fears have created compelling opportunities for our equity teams in a broad swath of sectors, including consumer discretionary and staples, energy, financials, industrials, and telecom services.

In other areas of the emerging markets, elections continue to create excitement and uncertainty. India recently outperformed on election euphoria, and the litmus test is now in Narendra Modi’s ability to deliver on his reform platform.

In the second quarter, investors assigned greater value to equities, with the developing stock valuations increasing about 5 per cent on a price-to-earnings basis since March. However, at 11.1 times forward earnings, emerging equities are still valued at a 28 per cent discount relative to those in developed economies, even though their returns are on par with developed-market stocks.

We continue to believe that the opportunity in emerging markets is still attractive.

Many countries are in the process of enacting much-needed reform, notably in China and Russia where large and powerful SOEs are beginning to focus on profitability and are slowly shedding their traditional role as instruments of the state.

We remain bullish on the outlook for emerging markets equities and believe that valuations are not excessive in all scenarios other than for a global recession.

James Donald (pictured on page one) has managed the Lazard Emerging Markets fund since its launch in 1997.

According to FE Analytics, it has been a top quartile performer in the IMA Global Emerging Markets sector, and has beaten its MSCI Emerging Markets benchmark, over one, three, five and 10 year periods.

In an article earlier this morning, FE Trustnet revealed that his fund has been the sector’s best performing portfolio since the emerging market equities bottomed at the end of January 2014.


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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.