Emerging Markets Trends: Whats Negative for One Market May Boost Another
Economic conditions have continued to deteriorate in emerging markets, and corporate earnings forecasts have fallen. Overall, emerging markets were down 4.3% in the third quarter, underperforming the developed world.1 In the midst of this negative news, however, we’re seeing a few bright spots start to emerge, and we’ve been able to add holdings that, in our view, became mispriced during market volatility.
EM economies hit new lows
China, Russia, Brazil, Indonesia, Turkey and South Africa have all recently experienced negative revisions in their gross domestic product growth due to weak private investment and consumption. Brazil, the largest Latin American economy, has officially entered into recession, and some economists have cut the growth forecast for China to below 7% for 2015, marking the first time we’ve seen a growth forecast for China drop below 7% in past 20 years.2
We see five main drivers for the overall economic malaise:
1. Commodities. The downturn of the commodity cycle is currently having a negative impact on trade — and, in turn, economic growth — for resource-dependent countries such as Brazil, Russia and South Africa.
2. Corporate earnings. Emerging market corporate profit margins are still depressed and returns on capital have come down, having caused businesses to cut spending on both capital expenditures and job growth.
3. Macro imbalances. Many emerging market economies such as Brazil and India are being challenged by macro imbalances, including high current account deficits or inflation, and these economies have been forced to tighten policies.
4. Lack of lending. Currently, we are seeing emerging market banks becoming more cautious in terms of lending in response to rising nonperforming loans. The tighter lending standards have slowed down credit growth and consumption.
5. Overcapacity. Some economies are still digesting the excess capacity that was built by the past credit boom. Typical examples are the manufacturing sector in China, and the commodity sector globally. The issue of overcapacity has contributed to the lack of recovery in private investment.
Fundamentals are starting to improve
Within this slower growth environment, we see five positive fundamental trends in emerging markets. It’s notable to point out that some of these positive trends stem from the same key drivers that are hurting other emerging market economies — this speaks to the vast differences among economies that are all included under the emerging market umbrella.
1. The bright side of the commodity downturn. While lower commodity prices hurt exporting countries, they typically benefit countries that are net commodity importers, such as China, India and many other Asian economies.
2. Another bright spot in commodities. Lower commodity prices also feed into lower inflation and raw material costs, which may allow businesses to reduce their cost of production and to improve profit margins.
3. Weaker currencies. Countries with large exposures to exports should benefit from weaker currencies against the US dollar. We expect that the economies of Korea, Taiwan and Thailand could see benefits from improving trade.
4. Rising dividends. With slower growth, emerging market corporates are cutting growth in capital spending and increasing free cash flows, and we are seeing rising dividend payouts and rising dividend yields.
5. Valuations. We see valuation becoming attractive. Emerging market price-to-earnings and price-to-book multiples are trading at a large discount to their own history. And, their price-to-book multiples are at a 30% discount to the developed world.3
How are we positioned for the future?
The third quarter saw the Brazilian market fall sharply, driven by anxiety about the presidential election. Invesco Developing Markets Fund added to its Brazilian holdings, especially Brazilian financials, to take advantage of share corrections.
Also during the third quarter, the fund cut its holdings in the Philippines and Indonesia, trimming our positions to take profits on high valuations.
As always, we are bottom-up stock pickers, and we evaluate investments based on their earnings, quality and valuation fundamentals. Going forward, we will continue to seek to maintain a quality portfolio of emerging market companies with strong business models, healthy balance sheets and sustainable earnings power.
1 Source, Bloomberg L.P. as of Sept. 30, 2014. Emerging markets based on the MSCI Emerging Markets Index.
2 Source: BNP
3 Source: Morgan Stanley. As of Sept. 30, 2014. Emerging markets based on the MSCI Emerging Markets Index. Developed markets based on the MSCI EAFE Index.
Capital spending is when companies use funds to acquire or upgrade physical assets such as property, industrial buildings or equipment. This type of outlay is made by companies to maintain or increase the scope of their operations.
Free cash flow is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.
Price-earnings ratio, the most common measure of how expensive a stock is, is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month period.
Price-to-book ratio is the market price of a stock divided by the book value per share.
Earnings is the amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year.
Valuation is the process of determining the current worth of an asset or company.
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