Seven years of plenty are swallowed by seven years of famine, such that all the plenty is forgotten;...
Seven years of plenty are swallowed by seven years of famine, such that all the plenty is forgotten; a pattern witnessed by Joseph, the Pharaoh and many emerging market investors today. The promise of growth that carried stock markets high in the early nineties was obscured by the various Asian, Russian and Latin American crises and the shimmering deceit of the tech bubble.
The latter was a global phenomenon but while the developed markets continue to trade above historical averages, the emerging markets are at their lowest ever multiples. The EM MSCI index was valued at a P/E of 9x against an average of 15x, a P/B of 1.4x against an average of 1.8x and the market capitalisation deviation from GDP was at minus 40%.
Are these multiples really saying that emerging markets will see their slowest ever growth next year? Last year, apart from Latin America, almost every emerging market posted GDP growth over 3%. China has been growing at an average annual rate of 7% over the past twenty years. Of the developed countries, only Ireland and Canada managed growth over 3%. There will have to be a radical shift in fundamentals for the S&P's P/E of 30x to be justified against the emerging markets' 9x.
The Sars virus, Argentina's debt default (now history) and worries about North Korea are legitimate concerns. The weak global economy certainly affects many emerging market economies dependent on exports. However, the developing consumer economies in Asia have begun to insulate them from the ailments of the developed world. For example, China's imports last year supported the price of most major commodities, while Malaysia and Thailand continued to develop service industries. The convergence of the Eastern European countries will give them the benefits and opportunities seen in Ireland's success.
After balancing these merits and demerits, the valuations of the emerging markets still seem excessively low. What can they indicate except another widespread crisis? Given the shocks of the past seven 'lean years' this is not unfair, although where it would originate is unclear. The main argument against another crisis is that almost every emerging market has already been burnt by one. In Thailand, Malaysia, South Korea, Russia and Mexico the weak institutions and regulations responsible for the various currency and debt collapses have been reformed. It remains to be seen if the new Argentine administration will do the same but the precedent is good.
The most pessimistic interpreter of the signs would be forced to acknowledge the current meagre valuations are good entry levels for the long-term investor. If one had invested in equities 14 years ago, the MSCI Emerging Market index would have returned 60% to the developed market index's -2%, despite the crises and crashes in the intervening period. However, one would expect to make greater returns beyond those of correct market timing.
Two mainstays of investment in emerging markets should be to avoid indexing and to invest defensively. This approach seems to contradict both the above index comparison and the higher risk-return equation an emerging market investor prepares himself for. In fact, it avoids country collapses and unforeseen risks and cultivates longer-term growth.
Passive investment in emerging markets is dangerous. By following the index, one is exposed to every country's crisis. Although Russia's default was unforeseeable, Argentina's was not. An active investor could take a zero weighting in that country, whatever the individual company merits.
In addition, not only many fast growing SME's but many countries are not included in the index. Estonia is an example. Investments in Eesti Telekom and Hansabank would have returned 68% and 65% respectively if bought last May. An index tracker would have wasted these opportunities.
The decision to invest defensively in emerging markets seems counter productive. Surely one chooses this asset class for its greater growth potential, accepting higher risk as a result. However, the higher growth inherent in the emerging market economies, owing to their improving economic conditions and deficits in basic and secondary products, is systematic. The growth affects all companies, thus an emerging market utility should grow more than a developed market utility. There is no need to double one's risk unless one wants to increase an already high return.
Short-term concerns abound, risk appetite is low and few investors are willing to invest overseas. Yet the developing growth story continues and history has shown that investments made at, or near, the trough yield tremendous returns. A defensive investment in the undervalued emerging markets could be the wisest choice at this point.
'Truly making a difference'
Avoidance, evasion and non-compliance
From 6 April 2019
Marcus Brookes appointed CIO