Are emerging markets on a rocky road to recovery?

With negative market sentiment and volatility in China, emerging markets appear to have a rocky road ahead. But that doesn’t mean they’re not up for the challenge, writes Stuart James.

A number of factors have contributed to the relative under-performance of emerging market equities over recent years, leading some critics to herald the death of this asset class. In our view, this reaction is overblown. 

Emerging markets have a track record of volatility, but the fundamental investment case for the sector remains intact and the outlook is more positive than some market participants claim. Weakness is presenting some opportunities to invest in good quality businesses.  

But there is no doubt that emerging markets are having to face up to some tough challenges. 

Tapering and supply of capital 

The tapering of quantitative easing in the US is making emerging markets realise they’re in a global competition for less capital that is more expensive.

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Certainly, strong domestic growth combined with weaker exports has led to a deterioration in the current accounts of some emerging economies and plentiful capital inflows triggered by US quantitative easing helped fund this position.

This resulted in an increasing reliance on foreign capital, making these economies in turn more sensitive to the Fed’s tapering and rising US interest rates. 

The key issue, however, is that emerging economies are adjusting. Emerging market currencies are now cheaper, which should help boost exports, while higher interest rates will slow domestic growth and imports.

This will eventually lead to an improvement in current account positions, underpinning currencies and allowing interest rates to come back down. 

Our hope is that competition for more expensive capital will prompt progress on further constructive reform within emerging markets. 

China’s economy 

Concerns over bubbles developing in the Chinese economy are feeding worries about the growth picture there.

The Chinese Government’s pursuit of interest rate liberalisation and consumption-led growth as a means to address the fundamental misallocation of capital has seen ballooning credit produce less and less growth in recent years. 

This has consequences for global and emerging markets’ growth.

As China’s economy slows and the nature of its imports change – for example the country’s vast hunger for natural resources – concerns over bubbles in the economy and, in particular, the property market come to the fore. 

Yet China’s administration has the scope and tools to stimulate the economy if it slows too much.

The banking system remains well capitalised to handle the current difficulties and a closed capital account gives the authorities greater control of the situation.

Ultimately the reforms, if pursued, will provide better investment opportunities in China. 

Corporate profitability 

Companies in emerging markets have been slow to react to weaker economic conditions, corporate profitability has declined, and in turn this is feeding negative sentiment.

Companies have had to contend with slower economic growth and margin pressures from rising costs.  

In contrast, developed market companies, particularly in the US, have seen profitability hold up as they have taken costs out of their businesses and have implemented significant share buyback programmes. 

Encouragingly, the recent difficulties faced by emerging market companies will refocus the attention of management on margins and removing excess costs.

Consequently, once the cyclical slowdown turns into an upturn, companies should report stronger top line growth as well as widening margins which will drive a strong earnings recovery. 

False alarm? 

It must be remembered that emerging markets have a history of scares, some of which turned out to be valid: the Asian crisis and ‘Tequila’ crisis being cases in point.

But the risks have changed, and what follows the latest bout of uncertainty will merely be a natural and healthy adjustment. 

Policymakers and company management are more than equipped to deal with cyclical change and to handle periodic crises of confidence – they have been here before.

Current volatility is spurring reforms both at the government and company level, while China’s slowdown and any asset bubbles should not threaten the country’s financial system. 

Emerging markets are in a stronger economic position than they were; there are no major economic imbalances and those that exist pale in comparison to some developed world countries. Debt and fiscal levels are far from crisis levels. 

Policy rates are still largely accommodative. Economic growth is stronger and demographics generally positive. Companies too are in good shape financially and are well positioned to capitalise on rising consumer wealth and opportunities in overseas markets.   

It is tempting to write off emerging markets in favour of developed markets, following developed markets’ strong outperformance over the last year, particularly for investors in Australian dollar terms.

But let’s not forget that the economic recovery in developed markets is fragile; risks remain and work needs to be done. 

The long-term fundamental reasons for investing in emerging markets – a growing middle class with increasing spending power, favourable demographics, and the potential to grow at a faster rate than developed economies – remain intact despite any short-term volatility. 

Also, much of the bad news is already priced in to emerging stock markets, which are now trading at a significant discount to developed markets and looking particularly attractive for local investors who have a long-term view and can stomach the short-term volatility. 

Far from being the death of emerging markets, we see the current volatility presaging a natural and healthy adjustment.

With this comes the opportunity to invest in good quality companies – a lot is already in the price.

The fundamental long-term case for emerging markets remains. 

Stuart James is a senior investment specialist at Aberdeen Asset Management.