US rhetoric on trade protectionism softens, investors are focusing on emerging markets’ fundamental attractions once more.
What a difference 100 days makes. When Donald Trump was inaugurated as President of the United States on January 20th 2017, headlines spoke of trade wars with the major developing countries. Yet by his milestone 100th day, on April 29th, 2017, the rhetoric had softened, a pragmatic tone had set in and sentiment in emerging market stocks had improved.
On the campaign trail, the Trump team talked of pulling out of the North American Free Trade Agreement (NAFTA) and accused China of currency manipulation. Since then, the confrontational tone has moderated. The US is looking to bring NAFTA up to date, while discussions to redress the trade imbalance with China have focused in part on how to improve exports of US agricultural products such as grain to the fast-growing country.
There has been a recognition that outright protectionism might have complex and unforeseeable consequences. This has allowed investors to focus once more on the attractions of emerging markets, which are set to expand faster than developed economies for years to come. Young and growing populations favour countries such as Indonesia, while structural reform programmes are unlocking growth potential in countries such as India. In aggregate, improving external account imbalances suggest a more sustainable growth trajectory less exposed to global flows. In addition, accommodative monetary policy supports many of these economies. With such a fair wind, many companies are prospering. There are exceptions and certainly risks but it’s the job of active managers to differentiate.
Why do these countries have superior longer-term growth potential? Put simply, the combination of increasing productivity and favourable demographics is a sure recipe for higher economic growth. To use the analogy of a bakery, installing more efficient ovens and hiring more people would increase the capacity for baking bread. By contrast, developed markets don’t have so much potential. They already have high productivity and their populations are ageing. So the effect of marginal improvements is skewed in favour of emerging markets.
The result is a wide growth differential. For example, India’s forecasted annual GDP growth rate for the financial year ending March 2017 was 7% and China reported annualised growth of 6.9% in the first quarter of 2017. Meanwhile, Europe and the United States are looking at annual GDP growth rates of 1-2%. Over time, this emerging market growth premium should translate into higher equity market returns.
AN IMPROVING PICTURE
Since Donald Trump’s victory in the US presidential election on November 8th, 2016, concerns have eased. This came on the same day that India’s government discontinued the use of all Rs500 and Rs1000 notes, accounting for most of India’s cash. The impact of these two events was significant. In the fourth quarter of 2016, the MSCI Emerging Markets Index fell by -4.1% (in US dollars). Most notably, as the Trump team has discovered that protectionist policy measures would have complex and possibly negative impacts on the US economy, it has taken a more pragmatic approach.
Turning to India, the economy appears to have shrugged off demonetisation. Consequently, global investors have refocused on emerging markets’ fundamental strengths, funds have flowed back into equity markets and the MSCI Emerging Markets Index has recovered by +11.5% in the first quarter.
Until November 8th, 2016 had seen a revival after three difficult years. When the US Federal Reserve looked likely to raise interest rates in 2013, investors who had been drawn to emerging markets’ higher yielding and riskier assets started to retreat home in what was dubbed the ‘taper tantrum’.
Additionally, high and rising inflation reduced the inflation-adjusted return on investments and made these countries less attractive to foreign investors. Emerging market economies with large current account imbalances and a reliance on foreign capital were most at risk from this capital flight.
Following the taper tantrum, many emerging market economies have introduced reforms to reduce their imbalances. During this time foreign currency reserves were growing, which cushions the impact of sudden capital flow reversals. In fact, more recently emerging markets’ aggregate current account position has moved into strong surplus.
Countries such as Indonesia have undergone a painful rebalancing, setting consumer spending on a more sustainable path and reducing their vulnerability to external shocks. Across most of these markets, consumer spending is growing and there has been a wave of reforms, including investment in public infrastructure in Indonesia, tax reforms in the Philippines, potential pension reforms in Brazil and India’s widespread reform programme. Furthermore, many countries have relatively high interest rates, creating the flexibility for monetary easing, while recovering commodity prices have supported commodity exporters.
More specifically, two events in 2016 provided a powerful tailwind. Firstly, the Chairman of the US Federal Reserve offered reassurance by saying that both domestic and international factors, such as China’s growth, would be considered when setting rates. Secondly, Chinese supply side reforms in sectors with excess capacity – such as steel and coal – combined with measures to stimulate property construction that had been introduced in 2015, started to boost the country’s growth.
NOT ALL EMERGING MARKETS ARE EQUAL
In our view, this return to focusing on emerging markets’ fundamental advantages is justified. As the Trump team is discovering, economies have become so integrated with each other that simply reversing globalisation is fraught with difficulty. For example, many leading US technology companies have supply chains stretching into China and Southeast Asia. Trade wars would have no victors.
But not all emerging markets are equal. We like Mexico because it is a play on the recovery in US growth and is witnessing strong domestic consumption. Furthermore, the US position on NAFTA has shifted, with talk of updating the agreement rather than ripping it apart. In addition, comments by Peter Navarro to create a “trade powerhouse” between the US, Canada and Mexico help demonstrate this shift in view. Improving sentiment has triggered a rally in Mexican equities and the peso. Stocks such as Walmex, the retailer, are gaining from rising consumer spending. Similarly, Banorte, one of the largest banks, will benefit from stronger growth in lending.
In India, Prime Minister Narenda Modi has promised a lot and is delivering. His ambitious demonetisation – a strike at corruption and the ‘black economy’ – is part of a wider reform programme. Notably, a national goods and services tax, proposed for introduction in July, will replace at least 15 different tax codes at the central and state level, reducing tax evasion, paperwork and logistics costs. He has also increased infrastructure spending, driven digitalisation that has led to 200 million previously unbanked Indians opening bank accounts and increased foreign investment limits for sectors ranging from insurance to defence manufacturing. When his BJP party won a sweeping victory in March’s Uttar Pradesh elections, with the largest margin of victory for 30 years, this was a vote of confidence in his reforms.
Brazil is an example of a country where the outlook is less clear. The policy change that followed the 2016 impeachment of President Dilma Rousseff triggered a strong rally in currency, bonds and equities. While the reduction in risk premium and a shift towards a lower rate environment could be long lasting, growth will be more challenging to restore. The country still has a large fiscal deficit and rising debt levels, thus the upcoming pension reforms will be an important indicator of progress in addressing this. Furthermore, government corruption is a risk to sentiment as shown by the bribery scandal surrounding the Odebrecht construction company.
Compared with developed markets, emerging market equities are generally looking more attractive, yet are trading at a valuation discount. They are growing their earnings faster, earnings revision ratios are on an upward trend and return on equity ratios are similar to developed markets.
Higher commodity prices, a stable and lower US dollar and encouraging global trade have been the main cause of this earnings revival. Within the technology sector, for example, Korean giant Samsung is predicted to grow earnings faster than developed market rivals in 2017. Notably, Korea, not China, is leading Asian earnings growth (in percentage terms). As emerging market firms continue to beat consensus earnings forecasts there is room for higher dividend payouts, further supporting stock prices.
GLOBAL PERSPECTIVE AND LOCAL KNOWLEDGE
The cloud that hung over these exciting young countries is lifting as the threat of trade war recedes. Compared to the turn of the year the outlook is more optimistic as external challenges recede. A weakening US dollar, the reduced likelihood of a steep trajectory in US rate hikes and strong Chinese economic momentum have proved positive surprises. While we still monitor these risks, such as the recent credit tightening within the Chinese economy or geo-political risks in relation to North Korea, we are certainly more optimistic than at the start of Donald Trump’s 100-day counter.
Even after the recent rally, emerging market equities are trading on valuations that appear attractive considering their superior long-term growth prospects, similar return on equity and lower valuations relative to developed markets (see chart below).
Krishan Selva, CFA - Client Portfolio Manager - Columbia Threadneedle InvestmentsBLOG COMMENTS POWERED BY DISQUS