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EM equity: a great diversity of factors

16 August 2018

Joaquim Nogueira, an emerging markets (EM) equity specialist at GAM Investments, provides his view on some of the major economies in this singular segment of the global equity universe, at a time when he feels that recent price action has provided a new opportunity to selectively buy EM stocks.

The universe of EM equity is extremely diverse. Listed within this same category are countries whose economic cycles are not at all related and whose markets are exposed to a great diversity of factors. However, in spite of this diversity, 2015 proved to be a difficult period for the segment in general. At that time, fears among investors reached a point where they moved away from the asset class to the extent that we described it as "under-owned, under-loved and under-bought". When markets finally bottomed, they were so oversold that valuations had reached truly compelling levels and we felt that it was just a matter of time before investors re-entered the space, starting a strong recovery.

Renewed buying activity ultimately resurfaced in an environment of low liquidity, which caused stocks and currencies to rise significantly in a short period of time. EM economies soon began to benefit from being in a counter-cyclical economic backdrop relative to their developed market peers. While Western central banks had been lowering interest rates to zero levels and printing money to avert the threat of deflation, their emerging counterparts had been battling the problem of inflation, raising rates. However, more recently, we have seen several of these economies control the rise in prices and start lowering interest rates, which has been reflected in economic confidence and corporate performance.

Intuitively, EM equities leapt to the front of the global performance tables until January this year when investors began to react to a combination of interest rate hikes in the US, the tapering of quantitative easing in Europe and, most importantly of all, fear over the impact of an impending trade war. From here, EM equity markets fell by around 18% (in US dollar terms) and we feel clearly that this represented a new opportunity to buy these assets.

Case studies

Russia – sanctions and oil

Investors have become preoccupied with international sanctions on Russia but the reality is that these have had very little impact because there is no will on the part of Western governments to cause significant damage to Russia. The sanctions are put into practice to cause noise and are typically directed at certain oligarchs or specific companies. Nevertheless, the shares of one of the country’s major lenders dropped 30% in spite of its domestic orientation. The lender in question also holds high-quality assets on its balance sheet and benefits from a high and rising return on equity. Furthermore, it is not remotely affected by the imposition of trade sanctions. In the end Russia’s dependency on oil revenues is the key and, as long as crude prices remain north of USD 60 per barrel, the country should continue to enjoy a very positive budgetary position, which is good for the economy and for business.

Brazil – a good phase of the cycle

Brazil is a singular case because it has a closed economy, which is experiencing chronic problems. The high protectionism that characterises it has led to the creation of a number of companies in industries where the country is not competitive, such as steel and automobile production. But nowadays the country consumes 90% of what it produces and only exports the remainder, which is limited almost to Embraer's aircraft and certain commodities. While it is important to remain aware of the problems posed by a lack of infrastructure, high electricity prices and political instability, the economic cycle has always been in evidence.

Indeed, Brazil’s cycle is highly dependent on its own level of confidence in investment and consumption. The country has endured both an economic recession and inflationary period, with interest rates being hiked into weakness to combat the latter. Conversely, we are now at the opposite phase in the cycle. Interest rates are falling and confidence is returning, which is evident from the meetings we hold with Brazilian companies. The numbers are again encouraging, so Brazil offers an attractive source of alpha at this point, especially in a scenario where we have a market friendly president elected in October (which seems to be more likely now with centre parties supporting Alckmin).

China – compelling valuations

The possibility of both a credit crunch and an economic hard landing in China has been highlighted by the media and investment community. This prospect has not materialised thus far and is unlikely to do so for the very simple reason of the Chinese government controlling the information. When the A shares crashed, the government simply called the brokers and demanded that they buy the market, which they did. A credit crunch can only be catalysed by the concept of 'everyone running for the exit at the same time', which the Chinese government would clearly not allow. On the other hand, the problems facing the country's banks are well known, but these have been 'silently' solved. It is a country with huge reserves of foreign exchange and this is a very powerful weapon against any economic problem that may arise.

Moreover, there has been a fundamental shift in China in recent years. It used to be the case that Chinese consumers possessed low purchasing power, but, in recent years, domestic consumption as a percentage of GDP has increased from 18% to 77%. This is an absolutely stunning transformation which means that China is no longer the export-dependent economy it was in the past, but rather a consumer economy. And this is evident in the composition of the country’s stock indices. Obviously, a trade war could hurt the country's economy, but not in an aggressive way. Regardless, stocks have fallen sharply and reached compelling valuation levels.

Mexico - Benign populist government

Mexico is a mystery! No one knows exactly what president-elect Obrador’s impact will be. Obrador’s early tenure could mirror that of Lula’s moderate/market friendly first mandate in Brazil. This might be the case as Obrador would not have accumulated that number of votes if he had not brought many of the moderates onside. Also his speech after the elections was very conciliatory, as well as stating that budgetary discipline is one of the priorities and that the independence of the central bank is key. Consequently, everything indicates that this will be a benign populist government, unlike those of Kirchner (Argentina), Chavez or Maduro (Venezuela).

Many of the risks are already reflected in asset pricing, including the troubled relationship with the US. Despite all of Trump's rhetoric, it is difficult to perceive him deliberately stemming the flow of remittances from Mexico to the US. Similarly, why should US companies compromise on efficiency, value and profit, by shifting Mexican industrial units back home? There is a lot of noise, but none of this is likely to have any impact on a significant scale.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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