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Aon Retirement and Investment Blog

AA View: Is it time to buy?

Executive Summary

  • Last year emerging market (EM) equities were the stand-out asset class but this year has been disappointing and it has given up that outperformance. This has resulted in media speculation about whether we have now entered a bear market for EM equities.
  • Our view is that EMs offer more growth and cheaper valuations than developed markets (DM), and consequently EM will outperform through the coming cycle. That said we recognize that EM equities tend to be higher beta and if the global equity market was to deteriorate there could be further underperformance.
  • A trade war between China and the U.S. is clearly bad news for EM but we think this is now reflected in EM equity valuations. We think there is a good chance the U.S. administration will want to have a trade deal agreed before the mid-terms, and if this occurs this could generate a relief rally. However, we also believe that trade tensions will remain for much of the next 2 years, and this will continue to create volatility.
  • Turkey and Argentina have hurt sentiment but they have very little direct impact on equity indices. Whilst EM debt indices are exposed to countries which are vulnerable to deterioration in global capital flows, we believe the long-term fundamentals for the overall EM equity market should be fairly immune.
  • Rising Fed Funds expectations and a strong US dollar are acting as headwinds for EM, and this could persist. Our medium term view, though, is for the dollar to eventually start weakening again. For investors with no or little exposure we think now is a good time to be averaging in to the market. However, we would still wait before being aggressively overweight EM. This might mean missing out on the bottom but avoids ‘catching a falling knife’.
China matters far more than Turkey and Argentina
Turkey and Argentina have grabbed the headlines this year as their currencies have plunged and interest rates soared. Investors have headed for the door as concerns about whether these countries large current account deficits (Turkey was 9.3% in May and Argentina 6.3% in Q1 2018) can be financed now that U.S. interest rates are rising.

However, these countries don’t directly explain EM equity underperformance. Turkey is just 0.5% of the MSCI EM equity index and Argentina is not part of it at all[1]. Chinese indices have had sharp moves up and down on news about tariffs that the US administration may or may not impose. However, according to FactSet data, US sales for MSCI China constituents are just 2.2% of their total sales (compared to 20% for MSCI Europe). Of the 25 largest exporting companies in China, 17 are in fact foreign owned. Many large U.S. listed companies, even if they don’t manufacture in China themselves, use Chinese and Taiwanese companies to produce their products which they sell in the US. Switching suppliers may not be practical and higher tariffs will likely mean increased prices (which will damage sales) and/or lower margins for US businesses too.

We therefore believe markets have been reacting inefficiently to news on trade. The potential impact on US profits and inflation has largely been ignored by US equity markets.

Chinese equity weakness has been in financials, autos and specific tech names
The threat of tariffs doesn’t explain the composition of Chinese weakness either. One of the weakest performing areas of the Chinese market has been auto-producers. These companies have relatively little in the way of US sales but the noise on tariffs has coincided with a big slowdown in domestic sales. It might be that uncertainty about tariff regimes has put off customers, in the expectation that prices could fall. Alternatively, autos are perhaps reaching ownership levels where sales would inevitably stagnate anyway. According to research by insurer L&G, amongst Chinese households with ‘middle class’ income levels, auto ownership has reached European levels. Together with restrictions on ownership in urban areas like Beijing, a slowdown in sales may have been inevitable. With policy increasingly focused on environmental protection consumers may be waiting for new cleaner cars to become available.

Another area of weakness has been financials. Even before the global financial crisis, investors fretted about the quality of Chinese banks' lending books. Then in response to the crisis, the Chinese Government allowed local governments to front-load their infrastructure plans. The stimulus undoubtedly helped stabilise industrial commodity prices and reduced the severity of the global recession but it has contributed to a huge overhang of debt. Government control of the Chinese financial system means that credit isn’t very efficiently allocated but it also keeps net interest margins (the difference between lending and deposit rates) artificially high which should cushion the system when bad debts are finally recognised. However, investor worries about the eventual size of these write-offs persists and the banks, like many of their European peers, trade at a big discount to book value. With Chinese policy makers wanting to stimulate the economy (see below), there are fears that banks may return to poor quality lending.

Some Chinese internet stocks have also been weak. Across the world there are concerns about whether internet companies are too powerful, but in China they have faced increased regulatory scrutiny. Their ‘fintech’ operations are facing increased regulatory oversight and activities such as online gambling and gaming are also coming under control.


Canaries in the coal mine?
A key question for long-term investors is whether Argentina and Turkey are ‘canaries in the coal mine’ or if their problems are largely idiosyncratic: the result of bad policies particular to these countries, or if the larger EM universe will implode due to excessive levels of debt.

We believe the big four in EM: China, Korea, Taiwan, and India, which make up 2/3rds of the index, shouldn’t be heavily impacted by dollar debt problems. Taiwan and Korea have the most exposure of the big markets but these levels of dollar debt tend to be concentrated in the exporting sector or currency hedged. We think a direct repetition of the problems that Argentina and Turkey have been experiencing is unlikely.

External debt issues concentrated in smaller economies


A tantrum not a crisis
Much of the damage during the Asian crisis of 1997/98 was caused by fixed exchange rates against the dollar. When the dollar started appreciating from 1995 this meant that these countries became increasing uncompetitive. Floating exchange rates and high levels of foreign exchange reserves make most of the larger EM’s far more resilient today. Many of the bears on China had assumed that China would keep its currency pegged against the dollar, and use up foreign exchange reserves to defend the currency, tightening domestic liquidity. China appears to be avoiding this course of action. Foreign reserves have been stable, with lows levels of intervention by the PBoC (People’s Bank of China) up till the end of August 2018.

Overall we think that this episode has more in common with the taper tantrum of 2013 than the Asian crisis and investors should therefore weather the volatility.

EMs provide plenty of longer-term growth potential
We think the long-term outlook for fundamentals in EM equities is strong. The chart below takes individual and IMF projections for country growth rates and aggregates them according to their current weightings in the MSCI index, JP Morgan’s local currency government bond index, and JP Morgan’s hard currency bond index. It compares this to developed market growth. Although we think that the projections of growth when weighted by (diversified) debt indices are too optimistic (because of the problems of EMs like Turkey), the IMF’s implied projection for the MSCI aggregate seems reasonable to us.

EM policy mix needs to improve


Overall EM economies are slowing rather than collapsing

Weakness in trade and manufacturing is being mitigated by strength in services and domestic demand
Over longer term horizons there is the potential for significant increases in the size of EMs. In a study last year PwC forecast that India would become the second largest economy in the world by 2050 (after China which already holds the top spot when measured in purchasing power parity terms). In the process it would add to its economy an amount of GDP equal to the present size of the economies of the US, Japan, Germany, France and the UK combined. Whilst we think this is possible, it is far from certain. India along with many other EMs has a far from optimal policy mix with structural reforms often being implemented slowly if at all. Further policy missteps could prevent India achieving its full potential.  At the start of the 20th century where it was widely assumed that Argentina would become one of the biggest economies in the world. Furthermore, rapid growth in an economy doesn’t necessarily translate in to high returns for the aggregate stock market: high growth often requires high levels of investment, restricting how much can be distributed to shareholders. However, we believe it does provide great opportunities for highly skilled stock pickers, who are able to identify companies that will prosper in such an environment.

In the shorter term though there are significant challenges these EMs have to overcome. In a recent report we argued that risk assets were entering a transition environment. We believe investors will demand higher risk premia for assets such as EM equities, which means that either profits will need to grow or prices will fall back. If economies weaken then profits could stagnate or even fall. How tighter dollar liquidity and trade wars impact growth will therefore remain important drivers of the market.

South Africa and Turkey are weak but Taiwan and China holding up

We think that growth overall is slowing rather than collapsing. Purchasing Manager Indices (PMIs) in both manufacturing and services suggest that, in aggregate, the EM economy is fine, with slower expansion in manufacturing being mitigated by a services sector which is still doing well. 

Chinese credit creation taking off again
However, there are certainly individual countries which are suffering. South Africa is already acknowledged as being in recession and Turkey is likely to follow.

Too early to get too excited about a China rebound

At 7% of the MSCI EM Index South Africa is the most important market to be suffering from economic weakness. The South African equity market though still has significant non-South African exposure. The biggest stock, Naspers (nearly 30% of the index) derives most of its value from its stake in Tencent (a Chinese internet and gaming company). Financials often have significant overseas operations, particularly in the UK, and many companies have exposure throughout Africa. Other important EMs such as India and Brazil seem to be holding up well currently, although India is exposed to the increase in the oil price (at the time of writing Brent Crude was touching $80/bbl) and Brazil is exposed to political risk in the run-up to the Presidential elections.

We think China though remains the most important country to watch. Back in June we argued in a paper (AA View: Global Monetary Policy Set to Diverge) that Chinese monetary policy was set to get a lot looser. Although in this week’s data release for August bank lending disappointed, overall credit creation was much bigger than economists had expected as there was a surge in corporate bond issuance. Eventually this will start to feed through in to economic activity. Once economic data starts positively surprising (shown by the yellow line in the chart below) we think that confidence in the Chinese economy will return and this will support EM equity markets. 

Positive outlook over longer horizons
Whilst the shorter term outlook for EM economies is looking weaker, we think that the longer-term prospects remain strong. In an AA View published in August ‘EM Equities Buy the Dip?’ we argued that the downside risks for EM are now reflected in valuations. Whilst we think that consensus estimates for forward EM earnings will fall a little, we suspect that markets already recognize this. In terms of forward P/E ratios EMs trade at over a 25% discount to developed markets (DM). This is close to the biggest discount in the last 20 years.

EM equities are trading close to their biggest discount in 15 years 

We therefore believe EM equities are now close to the bottom in relative performance terms versus DM. Whilst there is the potential for more downside, from either a big escalation of trade tensions, more pessimism about the global economic cycle, or another surge in the U.S. dollar, we think these risks are now largely priced in and further falls would represent an overshoot of fair value. Whilst idiosyncratic risks remain, with certain countries such as Turkey creating concerns, we think that (outside Asia) it is difficult for specific country factors to create broader contagion to the whole EM equity universe.
China remains a wild card but we think that it will grow at a rate which although slow by its own recent history is fast relative to developed market economies. Consequently we think that for investors who are not already investing in EM or have allocations substantially below their weight in global markets now isn’t a bad time to start putting capital to work.

Derry Pickford is a Principal on Aon’s Global Asset Allocation team, and is based in London, UK.

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[1] North Asia equity markets by contrast represent nearly 60% of the MSCI Emerging Markets index.

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