April 25, 2014
Emerging markets have faced lagging performance and myriad challenges in recent years, including slowing economies, concerns about China's financial system, reduced liquidity by the U.S. Federal Reserve, and geopolitical tensions. However, T. Rowe Price portfolio managers say many emerging markets offer unusually attractive long-term opportunities for investors, citing low valuations, a much stronger financial profile compared with prior crises, improving earnings, and a growing middle class with rising consumerism.
Emerging Markets Have Faltered Amid Stubborn Economic Growth Rates
Only three years ago, emerging markets led the developed world out of the global financial crisis, hailed for their superior economic growth and market performance. But more recently, many emerging markets have become the outcasts of the global investment landscape.
The recent performance gap illustrates the shift in sentiment.
Last year, global emerging markets, on average, lost 2.3% (in U.S. dollars), while the S&P 500 Index of large-cap U.S. stocks gained 32%. Only three times since 1990 have emerging markets underperformed by a wider margin.
In the three-year period ended December 31, 2013, the MSCI Emerging Markets Index lost 5% and the S&P 500 soared 57%. Emerging markets declined 0.37% in the first quarter of 2014.
How did this dramatic turn of events unfold? Through an unfavorable combination of:
- Slowing economic growth, in contrast to improving developed world growth
- Concerns about China's excessive debt and nonperforming loans
- U.S. Federal Reserve tapering of asset purchases, prompting capital flight from emerging markets and forcing central banks to raise rates to defend weakening currencies
- Inflationary pressures
- Disappointing corporate earnings
- The end of the commodity supercycle
With more than 20 developing nations holding major elections this year, T. Rowe Price investment professionals say the prospect for continued economic reforms in some countries has grown shakier.
"It could mean more headline risk, but it also gives emerging markets the opportunity to show how far they will go along the path of reform to help realize potential growth," says Andrew Keirle, manager of the Emerging Markets Local Currency Bond Fund.
With the fading of the two major tailwinds that propelled emerging markets in the last decade—the commodity supercycle and double-digit growth in China—Gonzalo Pángaro, manager of the Emerging Markets Stock Fund, says, "Emerging markets are undergoing an adjustment to a lower-growth environment and weaker global liquidity conditions. They are going through a balancing act of stabilizing growth while attacking stubborn inflation and reining in high current account deficits in some countries."
He adds, "This adjustment is causing some pain in the near term, but it is positive over the long term in that the key secular growth drivers for the asset class, such as the emergence of a large middle class of consumers, remain intact. As we return to a normalized world without Fed tapering and higher global interest rates, emerging markets should start to outperform."
Although wide economic disparities exist, emerging nations generally remain much stronger financially than during financial crises in the 1980s and 1990s.
In general, over the past decade, they have demonstrated better inflation control and significantly reduced their foreign debt (as a percentage of gross national income) while substantially increasing foreign exchange reserves, which provide more flexibility to defend their currencies.
Their central banks tend to be more independent than they were in the late 1990s, and most emerging market sovereign debt issuers are rated investment grade by the major rating agencies.
And while the gap has narrowed, the pace of economic growth in the developing world exceeds that of the developed world, a trend that is expected to continue. The International Monetary Fund forecasts emerging economy growth of 5.1% this year, compared with 2.2% for advanced economies. It estimates that emerging market economies, which now account for about 40% of global gross domestic product (GDP), will make up 49% of global GDP by 2020.
To be sure, China—a big driver of emerging market growth—is slowing significantly. What's more, concerns are mounting about the rapid increase in China's debt and nonperforming loans. However, T. Rowe Price portfolio managers say that a higher-quality, more sustainable rate of growth could be achieved.
While central banks in several emerging markets have raised interest rates to defend their currencies over the past year, the measures reduce currency pressures going forward. Also, some of the more at-risk emerging markets have significantly reduced their current account deficits, reducing their vulnerability to international capital flows.
Indeed, emerging markets may have reached an inflection point in which their fundamental strengths offer opportunities for long-term investors.
After falling precipitously last year, the Indonesia stock market, for example, soared in the first quarter of 2014 as the country raised interest rates sharply, narrowed its large trade deficit, and saw its currency appreciate.
Meanwhile, valuations in equity emerging markets have become unusually attractive, trading at about 10 times estimated 12-month earnings—well below their historical average and at the widest discount to developed markets, including the United States, since 2005.
T. Rowe Price portfolio managers expect emerging market corporate earnings to stabilize amid improving profitability against a backdrop of stronger global growth.
"Several Brazilian corporates, after a tough run for a couple of years, are again reporting decent earnings results—not because the Brazilian macro picture has improved, but because they are focused on making money in that environment," says Scott Berg, manager of the Global Growth Stock Fund.
Verena Wachnitz, portfolio manager of the Latin America Fund, notes, for example, that a large Brazilian bank has improved its return on equity to more than 20% from 17% "despite low growth and intense competition from public banks by focusing on fee income and efficiency." She expects the bank to grow earnings at a double-digit rate this year and next year.
Similarly, other companies have improved revenues and margins by containing expenses and taking advantage of scale to negotiate contracts with suppliers and reduce (non-rent) occupancy costs.
"In a [weak economic] environment in which self-help is necessary to grow earnings, management quality has become more important than ever," Wachnitz says.
While some observers contend that the rise of consumerism in the emerging countries has played out, Pángaro disagrees. "We are in the early stages of a multiyear growth cycle," he says, adding that "long-term trends are underpinning this growth, including a rising middle class and increasing consumption and real wage growth."
Selectivity Is Key
With some emerging markets pursuing economic and government reforms more aggressively than others, Berg says investors should no longer view them as a homogeneous asset class. In recent years, there has been significant dispersion in emerging market equity performance even within the same country, region, or industry.
Over the three-year period ended March 31, 2014, for example, the MSCI Emerging Markets Latin America Index declined by about 24%, while the MSCI Emerging Markets All-Country Asia ex-Japan Index gained about 3%. Corporate earnings have been strong in Asia but weak in Latin America.
As a result, more selectivity is now required than when the rising tide of global commodity prices and China's booming growth tended to lift all emerging markets.
"We expect to see more divergence in economies and stock market performance in coming years," Pángaro says. "Being more contrarian and investing in the right countries and the right companies will be crucial for producing good returns over the long term."
Pángaro has been taking advantage of the market volatility by adding to holdings of high-quality growth companies that have performed well over the long run and achieved consistent earnings growth but have been damaged by the recent economic headwinds. Such companies are expected to emerge from this environment stronger by taking market share from weaker competitors.
Berg says that, despite the current skepticism, "There are numerous countries, particularly in Southeast Asia, where the long-term fundamental outlook remains very strong."
On the fixed income side, Steve Huber, manager of the Strategic Income Fund, sees opportunities in emerging market debt, particularly that denominated in U.S. dollars. "We are becoming more positive on this sector, which appears to be moving through a necessary adjustment period rather than a systemic debt crisis," says Huber. "However, there are a number of risks, such as global growth, stubborn inflation, current account and fiscal balances, and upcoming elections."
Certainly, these and other near-term market risks remain. Nevertheless, T. Rowe Price portfolio managers say that selective emerging markets and stocks offer significant long-term potential and that this is an opportune time to invest.
"Over the longer term, the emerging world is likely to retain an earnings growth advantage, which is the predominant driver of equity returns," Berg says. "If you can acquire that growth potential at attractive valuations, it should add meaningfully to prospective gains. The key question is where and when the earnings growth story will emerge again."
Todd Henry, an emerging market portfolio specialist, advises investors to "manage expectations when it comes to emerging markets. Maybe they don't outperform developed markets to the extent they did from 2000 to 2008, but we think there is very good potential that they will outperform—even though this current period of relative weakness may not yet have run its course."
Chris Alderson, head of international equity, adds, "Emerging markets are very inexpensively valued now, and I still think there is a great long-term structural story in some of the big emerging economies that have young populations and, therefore, have more catch-up potential. These markets have been through many crises over the past 13 years, and they will recover from these setbacks as well. This could turn out to be the major contrarian trade of 2014."
Investing overseas generally carries more risk than investing strictly in U.S. assets due to factors such as currency risk, geographic risk, and emerging market risk. Because of the concentration in rapidly developing economies, investing in emerging markets involves a high degree of risk.
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