VALUE IN EMERGING MARKETS?

Headlines

• Situations such as 1998 which saw the default of Russia and high currency pressure within emerging markets had huge effects on returns this particular year
• The recent tax changes in the US by the Trump administration combined with faster economic growth in the US and slightly slower economic growth in emerging markets added to the pressure on emerging markets currencies
• There are no signs that the upward pressure on the dollar will decrease in the next 6 months
• Another issue is short term wage inflation which can lead to higher taxes

Key themes

A huge incalculable risk are sanctions by the US. President Trump’s governing style of declaring sanctions via tweet has become a substantial risk to investors in emerging markets, because it leads to a sell out within a short window of time. 

Another factor is trade, which currently presents the greatest risk within world markets and it will be the biggest risk factor for approximately the next 2 years. One reason for this is President Trump’s firm belief that the US has been treated poorly by their trade partners. The other reason is that it is one of the main topics by which he solidifies his voter base.

The topic will become more of a focus for the upcoming presidential elections in 2020. This will increase the necessity for President Trump to re-write trade deals and pressurise trade partners into accepting the terms he is setting through the threat of tariffs or actual tariffs. The most likely targets will be the European Union and China.

The interesting point about emerging markets today is the highly discounted valuations. Emerging markets equities are selling at the highest valuation discount to US equities since 1998. This begs the question of whether this is the result of US equities being overvalued?

At present, emerging markets are quite scary for investors around the world and there is a clear flow from emerging markets to the Nasdaq. Generally, markets do not want to think too much about valuation. An interesting development this year is the good performance of deep value in emerging markets, which is the first time since the early 2000’s.

Another question that arises is whether we are at a time right now where the leadership of the markets is starting to change? If there is a change of leadership of the markets, deep value can be expected to be in the leadership position for the next year, followed by a period of relative value for the following 3 to 4 years based on historic patterns. At the moment most people are not positioned for that and continue with strategies which are not that value oriented.

A participant raised the issue of how much dollar denominated debt is held within emerging markets and how much of a threat that represents given the continuous rise of the US dollar?

There has been a significant reduction in dollar denominated debt by a lot of companies in the emerging markets. There is also a chance for a weakening of the US dollar given the growing deficit in the US. Nevertheless, a continuous hike of the dollar would represent a serious problem for emerging markets.

Valuations in emerging markets have been lower in the past 15 years. Research suggests that there is a relationship between relative discount and emerging market profitability.

Since 2016 emerging market companies have been more careful regarding capital expenditure which led to rising profitability and earnings per share, regardless of the current development of the dollar. If that trend continues it is possible to see a rise of 15% in ROE’s for emerging markets.

Conclusions

The emerging markets are facing a multitude of challenges ranging from the unpredictability of the US government, to a rise of the dollar and political instability. But given all these challenges, emerging markets have performed well over the last few years and higher capital expenditure within the developed world, can represent a further boost to emerging market companies.

Expert: James Donald, Lazard Asset Management