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Aon Retirement and Investment Blog

Do Emerging Market Equities Still Provide Upside for Investors?

Are you thinking enough about Emerging Markets?
Whether or not you have explicit exposure to emerging markets (EM), we all need to pay increased attention to what is happening in EM. At market exchange rates the US is still over 60% bigger than China; however, in purchasing power parity terms, a measure which doesn’t get distorted by exchange rate fluctuations, China is the largest economy in the world - at over 18%. EMs now contribute 60% of global GDP and by 2022, China and India should be bigger than the US, EU and UK put together. China in particular is already a major driver of the global economy and financial markets. “China credit tightening” has been rated as the biggest tail risk for global markets in the Bank of America Merrill Lynch Survey of Fund Managers in May and June. Back in 2015 and early 2016, a recession in China was thought of as the biggest global tail risk. We believe that China’s hard landing risks are largely overstated and that Emerging Markets as a whole offer greater longer term growth than developed markets. Although we are more cautious near-term owing to EMs stellar performance year-to-date, we still believe that over the medium term, improving return on equity, higher economic growth, and attractive valuations will mean that emerging markets will significantly outperform developed markets.
Should we worry about China?
China is not only by far the biggest component of the MSCI EM index (28%) but it is also an important driver of sentiment for the whole index. If there was a hard landing – where China’s GDP contracted – the repercussions would be felt throughout the world. EM though would be particularly badly hit given the trade and investment linkages.

So what is it about China that has investors so concerned? 

In a word: debt. Non-financial corporate debt in China has climbed to 166% of GDP, which is higher than the level reached in Japan just after its credit boom broke or South Korea during the Asian crisis. This debt build-up is associated with excessive fixed capital investment and breeds concern that there could be a repetition of the Asian crisis for China. The only countries with comparable levels of debt to GDP tend to be relatively small, advanced countries such as Ireland and Sweden, with the former still adjusting from bursting a credit bubble of its own. China’s total private non-financial debt at 210% of GDP, is greater than in the US just prior to the Global Financial Crisis (GFC).

Elevated levels of debt inevitably leads to large amounts of column inches in financial newspapers being devoted to questions such as “Will China have a Lehman Moment?” We believe that such a scenario is unlikely. Given China’s preponderance to save even the smallest of institutions, the chance of a systemically important institution failing seems slim. Provided China avoids any policy missteps over the next few years, the government has ample fire power in terms of ability to borrow from domestic savings, together with ample FX reserves and controls on capital flows, that it can easily rescue the financial system if it gets in to trouble.

Of course, it is this practice of standing behind institutions that has entrenched “moral hazard” (disregard of the risk in investment and lending decisions because of the knowledge that the loan will be bailed-out) and has meant that the quality of lending has been poor. Much of the most egregious lending has been by the smaller City Commercial Banks and Rural Credit Cooperatives where lending decisions are often controlled by local politicians. This means we’re more likely to get smaller banks failing than systemically important ones. These banks are largely state owned, which means that allowing widespread bankruptcies of these entities will be “robbing Peter to pay Paul”. It is not surprising that most, although not all, entities that got into trouble ended up being bailed-out. 

We believe China should be able it to ride out a bad debt cycle and, as previously mentioned, the chances of a China hard landing are for the moment relatively low. In terms of historic analogies, it will look more like the 1980’s US savings and loans crisis than the Global Financial crisis of 2007-2009. Whilst the S&L crisis was expensive, it was sufficiently spread out over time that its macroeconomic impacts were limited. However, if China doesn’t eventually reform its growth model the chances of disaster will start to increase. China will in one form or another be appearing in the Merrill Lynch’s fund manager survey for some time yet.

Time to Buy EMs?

If China hard landing risks are overstated, as we believe, does that mean we should buy EM? Aon Hewitt turned bullish on EM back in January. To reflect the stellar performance already this year, we have turned a little bit more cautious over the immediate outlook but, we remain optimistic about the longer-term outlook. We believe Emerging Markets are attractively priced, and well positioned in terms of demographics and potential growth rates. Of course, there are risks other than China. Two other commonly cited ones, commodity price weakness and Fed tightening. We believe that these problems are overstated. In the last Federal Reserve hiking cycle EMs outperformed. Indeed it seems plausible that EM’s could “climb a wall of worry”: the market rises as investors discover that the “bad news”, which had led them to put EMs on a discount, isn’t as detrimental as they had feared.

Another concern with EMs is their vulnerability to geopolitical risks. South Africa, Brazil and Russia, three of the five “BRICS”, which generated such investor excitement a decade ago, have been affected by either domestic political problems or, in the case of Russia, international sanctions. Although by no means the sole driver of their economic problems, it certainly has helped market performance. Could India and China also be derailed by political risks? In terms of domestic policy, economists have generally been impressed by India’s PM, Narendra Modi, structural reform orientated agenda, including the introduction of a consumption tax which replaces the previous indirect tax system which often made it easier to trade abroad than another Indian state. Whilst only a tail risk, the rise of nationalist politicians such as Yogi Adityanath, the Chief Minister of India’s Uttar Pradesh state, worry some analysts about internal religious harmony. Tense relations with Pakistan and China also represent another tail risk. In China, power looks like being further concentrated around President Xi Jinping, after the Party Congress in October. North Korea, Taiwan, and the South China Seas all are potential flashpoints although, for the moment, these look like tail risks rather than anything that should overly concern investors.

We argue that much of the disappointment over 2010 to 2016 was driven by one-off events. Because MSCI measures earnings in USD terms, weak currencies depressed the dollar value of earnings. There was also a decline in return on equity, with the recession and corruption scandal in Brazil being a major driver of the collapse in overall profitability. The worst is now over in Brazil, although political turmoil remains a risk. Even if Brazilian earnings were to collapse again, they’re already such a small proportion of total EM earnings it won’t have the same impact on the overall index.
With EM economic growth set to reaccelerate, both currencies and profitability will continue to recover.

Faster growth in EM is also priced cheaply. EMs trade on just over 12 times forward earnings versus 16 for developed markets. Some of the EM cheapness can be explained by sector composition: it has greater exposure to sectors such as financials and materials which trade on lower P/Es, but even adjusting for this EM still looks cheap. In the medium to long term, we believe that EMs will therefore outperform developed markets.
Derry Pickford is a Principal on Aon Hewitt’s Global Asset Allocation team, and is based in London, UK.

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