Getting Back Into Emerging Markets

A three-part return trend

Originally published in the April/May 2014 issue

Last year was awful for emerging market (EM) equities, returning -2.6% compared to the S&P 500’s +29.6%, a difference of more than 30%. February and March this year were better (+6.5%), pulling the index back to just under where it was at the start of the year, slightly down -0.4%. With EPFR Global reporting earlier in April that this was the first time this year that dedicated EM bond and equity funds received positive inflows, is this the start of a trend back into EM? I think there are three large, important moving parts, set out below.

Tactically we are looking good for a bounce, but as the year progresses we are moving strategically to the unknown. Entry via diversification is a great way to start, specialising after planning and preparation, the follow-through. Besides the potential financial rewards, remember that the people in these countries aspire to better things, and choosing wisely aids them in achieving this aspiration.

Part I: Tightening and monetary policy normalisation
Monetary policy is about the quantity of money in the economy, setting expectations for its price, and the tools that are used to meet them. Normalisation is how quantitative easing (QE), the currently unusual but major tool, is being withdrawn from use. Tightening is a rising cycle of US interest rates.

It’s well established by observation that quantitative easing has had a substantial effect on emerging market (EM) equities – positive on implementation, negative on withdrawal. Three points:

  1. Markets at some point will have to reckon with tightening. It’s one thing to keep the price of money less cheap by buying less bonds (so holding rates down), but quite another to make the money more expensive by raising rates, and putting them up. How this will play out should be negative; how negative is an unknown (past episodes are not encouraging).
  2. Conversely, loosening, which is more quantitative easing, can’t be ruled out. The pools of liquidity from which this may come will be smaller (the ECB and Japan), but there is an indication that it could happen, most likely in Japan. QE by EMs is also up for grabs, as Russia and India have engaged in the past, and I don’t see why more advanced economies like Taiwan and Korea can’t do the same, if they had to. Though unlikely, if the US recovery takes a turn for the worse the Fed’s stance on data dependency may mean further asset purchases will be required, prolonging the recovery process.
  3. Instead of normalisation by withdrawal from use, QE could also be normalised by prolonged use and acceptance. As we are now familiar with the Taylor rule and what it would imply for growth, inflation and the setting of interest rates, we are progressively getting used to the Evans rule, with unemployment, inflation and asset purchases inflating the central bank balance sheet.

If you believe point 1 will happen and has impact outweighing all other factors, sell. If you believe point 2, buy. Point 3 is trickier, as it implies that there will no longer be outsize changes towards its use or withdrawal (so its impact will be just as significant or, say, mildly stronger than a rate cut or hike). Normalisation in this sense could imply a return to a non risk-on/risk-off environment whilst the instruments are still at play.

Conversely, where it’s not used and the market expects it, it could be punished as it was prior to the restart of the successive QE rounds, or as we would see whenever central banks are considerably behind the curve. Whether or not QE is available is beyond the scope of this article, but the central bank has to be willing, has to be capable (inflation likely not a concern at all), and has to be able to get away with it (sign-off from political masters practically a prerequisite).

None of the above is meant to take away the importance of fiscal policy in long-term decision making.

Part II: China – growth, debt and rebalancing
In global emerging markets China is important because it is the world’s second-largest economy, the largest contributor to growth, and the largest commodity and car market in the world. It also has the world’s largest standing army. In terms of asset prices, China is important because there are question marks over its growth sustainability, and levels of rising debt. Underlying these question marks come a couple of propositions: i) compared to private market forces, the state is always inferior at capital allocation, and ii) debt beyond a certain level becomes divorced from the ability to repay it, and additional debt delays the inevitable.

If either is dangerous enough, combining points i) and ii) must surely be explosive for growth. Will China blow up? Two points, primary and secondary:

Primarily, this is not Star Wars. The problem is, everyone thinks China is the Galactic Empire, and the Death Star will blow up. Victory by the Rebel Alliance is assured. Some hedge fund managers think they are Jedi, Luke Skywalker even, believing they are the chosen ones who will launch the photon torpedos that will make their fortune.

For those unfamiliar with the iconic 1977 space opera, this movie is about an adversarial conflict between the Light and the Dark side, represented by underdog freedom fighters and religious warriors (Jedi) that make up the Rebel Alliance, versus the incumbent, authoritarian government and unholy warriors that make up the Galactic Empire. The plot in this first of nine movies revolves around a very large, very expensive Empire superweapon, the Death Star, capable of destroying entire planets. Unfortunately, this weapon came with a design flaw, which the protagonist, Luke Skywalker, exploits, destroying it, achieving a heroic victory for himself, and for the Rebels.

A subtext behind this is the creator, George Lucas’ critique of the ideal political and economic system – with the liberal, democratic, US-Western European capitalists as the Rebel Alliance, and the so-none-of-the-above Soviet Union as the Galactic Empire. The Death Star embodies overcapacity, a planet-sized white elephant providing workers with jobs. When it is destroyed at the end of the movie, it takes growth out with it.

Here are the problems with the “Star Wars narrative”: a) What if the Empire decided it was wrong?; b) What if the Empire voluntarily chose to decommission the Death Star? What if, to make a point about dealing with overcapacity, they elected to evacuate all personnel, and press the self-destruct button? What if they surrendered?; c) What if they are the good guys?

You watch the movie, know how it ends, and so decide it will be like that in real life.

So, one sees the capital misallocation, recognises the debt, and – oh look, a Ponzi scheme! Must be a financial disaster. But this isn’t a movie. People learn from mistakes. But they also make new ones. Deciding whether or not China blows up, one needs to seriously consider the following:

  • Leadership: whether the people in charge get it and are taking steps to avoid it from happening.
  • Financials: whether the financial system is capable of disintermediating itself from the core out into a periphery, to reallocate the pools of capital closer to their economic sources, and hold them accountable.
  • Fundamentals: whether or not the underlying businesses which created this liquidity is strong enough to support it, and if not, what steps are being taken to strengthen them… or let them fail in a way that doesn’t threaten the system.
  • Accounting and debtor-creditor relations: whether mark-to-market is sufficiently flexible, and whether the relationship between debtors and creditors provides them with the capability to renegotiate or transmute obligations.
  • Capital controls: whether money, unhappy with how it is being allocated, can leave the economy – or whether fresh capital from the outside can be introduced.
  • Liquidity: whether the policy levers, in the form of rate and FX controls, liquidity injections and withdrawals, banking rules such as loan/deposit ratios and capital requirements, and total social financing work in sufficient coordination to facilitate points 2) and 3).
  • Market: whether the lack or presence of all of the above is already in the price.

I think this it’s fair to say that points 1), 4) and 5) seem OK. Point 2) has to be disaggregated from Ponzi financing which exists to a significant degree, which will probably be ultimately borne by households, tempering consumption.

Point 3) has a social issue in maintaining an adequate level of employment. Point 6) is intelligible, but rather complicated to evaluate cohesively (and if you did get parts of it perhaps the time spent explaining it is better used making money instead, as did the export invoicers).

Point 7) has a case for being already reflected in the stock market, a 2010-2013 four-year CAGR of -10.4% for the Shanghai Composite versus the S&P’s +13.5%, and an end-2009 to end-March 2014 decline of -38% versus appreciation of +68%, a 106% underperformance.


a) The path of most resistance is a China that doesn’t quite slow down, sticking above 5% growth for the next 10 years.
b) Assessing the liquidity adequacy for financial and fundamental adequacy (as per points 2) and 3) above) is probably too big, and too difficult – focus on exposure and actual instruments.
c) So it’s worth stress-testing the balance sheets of Chinese names in your portfolio for their ability to meet financing requirements, and loan repayment ability, especially if they happen to be paying below-market rates.
d) Opportunity lies in credit, both to its providers and to its successful users for economic purpose. Quasi-credit (or deposits funding credit, as per the internet companies) works too.
e) Policy support points towards industries with solid fundamentals, but this is even better where the private sector is left to reap the benefit (as gas distributors such as ENN Energy and Towngas China have).

Believing China will certainly collapse is Star Wars nonsense – don’t let George Lucas decide for you how to think about China.

Secondarily, being really bearish on China also means being bearish elsewhere, especially in Asia. The idea that ASEAN, Korea and Taiwan will emerge unscathed is laughable. If resource nations as far away as Brazil and South Africa can feel the pinch, you can bet China’s actual neighbours and trade partners will suffer. If you find yourself short China, yet net long in Asia, and are not hedging or making some kind of relative trade, I’d look again.

Part III: EM – leverage and selectivity
In a sense, evaluating EM in a post-QE world and slowing China marks a departure from leverage – less debt (financial) in the West, and less China-fueled (operating) in the East. This can best be seen in how badly the materials sector has done post-2010, with less demand and dearer capital to finance its supply. This doesn’t mean that leverage will go away.

Financially, EM corporates have been noted by the IMF as issuing more debt than ever, with the help of overseas subsidiaries – at some point this will be tested! Chinese corporates have also taken sizeable loans overseas in Hong Kong and Taiwan, making their banking sectors vulnerable, if they were collectively to get into trouble. Operationally, (and more positively), the US is back on track towards trend or even above trend growth, providing old-school rejuvenatory demand. These shifts provide EM the chance to grab the fundamental soap amongst the credit bubbles, providing the latter aren’t big enough to spoil the experience.

1) The hub-and-spoke company – Turkey, Chile, Taiwan
These set of markets contain higher-quality companies which are used to dealing with customers outside their own country. Having conquered their domestic market, they have leveled up to the wider region. So Turkey provides access to Europe and the Middle East, Chile to Latin America, Taiwan to China.

For Turkey and Chile, the opportunity comes from separating the macro vulnerabilities of the countries from the micro circumstances of the companies. Chile may be reliant on copper, but it’s not going to matter much if most of Cencosud’s revenues come outside of it, across different countries, in a sector less economically sensitive.  

For Taiwan, a twist is provided by the recent student protests. Indicative of significant changes in trade policy, the country is being co-opted as part of China’s rebalancing process. In doing so, Taiwan is being incentivised with more access to the mainland, and less patriarchy over which trade pacts it forms elsewhere. This should cause it and companies able to take advantage of it to eventually rerate upwards. Representative names: Koc joint ventures (e.g., Turk Traktor, Ford Otosan), Cencosud and Falabella, Uni-President.

2) The energy sector – China, Brazil, Russia
Global energy demand is now driven by emerging markets. Countries with not enough supply have had to pay up to acquire oil assets abroad, going deeper into debt. Additionally, declining rates of output at home have increased expenses. Politically, the oil majors’ links with the state mean they will occasionally be co-opted to make non-economic decisions, such as Petrochina’s loss-making imports of natural gas, and Gazprom’s role in the ongoing Ukraine saga. These reasons have caused the MSCI sector to derate to below book value, with the end-February 2014 P/B ratio of 0.84 being 51% below its 10-year historical average (the index being 1.52 and 23% below), by far the cheapest sector in EM… and the most opportune.

If you believe that this can’t go on, then moves like Sinopec’s divestment plans and Petrobras admitting it has a problem by issuing a debt warning (never mind the political brouhaha) provide indicators that the cycle is ready to turn. Or you might decide that the political risk is worth paying less than three times earnings for what is effectively the world’s largest source of gas supply, that sits next to the world’s largest source of gas demand… with a monopoly in Europe.

Elsewhere, the rising cost of conventional energy contrasts with the falling costs of alternatives. Solar is now cost-competitive on an unsubsidised basis in a number of EMs for power generation. Given that EMs typically subsidise the cost of energy, this means they can save money by co-opting it into their energy system – a no-brainer. And since the sun is free, and costs are still falling, it’s only a matter time before demand goes parabolic. Representative names: Sinopec, Petrobras, Gazprom, First Solar and GCL-Poly.

3) The Middle East and North Africa – UAE, Qatar, Egypt
People in charge like to stay in charge. In order to keep the post-Arab Spring population happy, the leaders of the Gulf states have started to spend a lot of money on construction, real estate, and infrastructure. There’s a boom going on now in the Middle East, and capital will be needed to finance it – favouring the financial sector as well. Representative names: Dubai Financial Market, Qatar National Bank, Talaat Moustafa Group.

Ryan Soh has six years of investment industry experience at an emerging market asset manager. Soh holds a law degree from Merton College, Oxford, and has passed the Chartered Alternative Investment Analyst and Energy Risk Professional exams.