Emerging markets have had a rough go recently, but that’s no reason for investors to run, says Phil Langham, a U.K.-based senior portfolio manager with RBC Global Asset Management.
It wasn’t long ago that emerging markets were outpacing developed economies. The growth average for emerging markets over the last decade was 4.2% higher than developed nations; around the time of the credit crisis, it reached about 6%, explains Langham.
The last two-to-three years have seen emerging market growth slowing as developed economies recover. “Emerging markets had probably been growing too fast, and credit growth in a lot of markets had been very fast,” Langham says.
Flows to emerging markets have slowed partly because of tapering, and partly because of tighter liquidity conditions. Langham notes real bond yields in emerging markets have expanded for three main reasons:
1. U.S. Treasury yields have gone up;
2. emerging market bond spreads have moved from their tightest in January 2007 (about 220 basis points) to the middle of their long-term range (around 350 basis points); and
3. inflation’s come down.
These markets have also seen substantial currency weakness, particularly India, Indonesia, Turkey, South Africa, and Brazil. All these countries, Langham adds, have elections this year, and for India and Indonesia “there’s a strong likelihood of a change in regime, which we think will be positive, with more pro-market policies.” That’s one reason he favours them.
Valuations have become much more attractive, Langham notes. “Relative to developed markets, in both P/E and P/B terms, emerging markets are trading at over a 30% discount. The historic average is closer to 15%.
“If you look at absolute valuations, we often find that P/B works very well in downturns. We’re currently at a P/B of between 1.35× and 1.4×,” and they haven’t been this low since the Asian crisis.
Langham says historically he’s favoured consumer sectors. They’ve done well over the last four years and his long-term view is still positive. He’s starting to increase weightings in technology and industrials, which will benefit from the recovery in developed markets. He also has an eye on healthcare.
He’s underweight energy and materials and will likely stay that way. “We’ve seen a gradual shift away from [emerging] markets being driven by commodities…to being driven by consumption and domestic demand. That’s likely to continue as there’s a growing middle class and we’re seeing strong wage growth, unlike in the developed world.”
Expect commodity demand from China to dip because it has enough capacity in areas such as transport, infrastructure, residential property and steel, says Langham.
“One concern is the sustainability of growth in China. Credit growth over the last few years has been very high—perhaps too high. We’ve gone from credit being around 150% of GDP four or five years ago to being 220%. Policymakers understand they need to reform the economy away from state-owned enterprises more toward the private sector, and they are starting to implement these reforms.”
Langham notes growth in China has followed a pattern over the last three years. In the first half of the year the pace of growth would lag estimates. Policymakers then make adjustments for the second half that increase growth and help meet targets.
“So I think it would be dangerous to assume that [a growth target of ] 7% to 7.5% won’t be met. They have a very strong history of meet[ing] targets.”
Langham suggests China is underinvested in social infrastructure, which includes metro, sewers, the power grid, healthcare and education. “Healthcare is still a relatively small percentage of GDP, around 5.2%, and we would expect that to increase over the coming years.” It’s an opportunity both domestic and foreign firms can capitalize on.
He says corporate governance in emerging markets is improving, but to avoid potential problems, he emphasizes cash flow data, because it’s much harder to manipulate these numbers than earnings.
“We also spend a lot of time interviewing management and competitors. Discussions with management are mainly about their overall vision and strategy. We try to get a feel for how they treat employees and how innovative they are.”