Stocks in emerging markets have had a tough time this year, plunging during the first six months and leaving many investors shaken as heart-stopping drops punctuated a post-summer recovery.
Some investing pros have argued the best times for emerging-market investing are over, citing factors like the inevitable end of the Federal Reserve’s bond-buying program and the sluggish progress in converting EM countries like India, China and Brazil to consumer-driven economies.
But many experts at Wharton and elsewhere say the obituaries are premature. The biggest mistakes, they argue, are to lump the diverse EM economies into one and to take the short-term view. Many say EM stocks, chosen carefully, are now quite attractive, though EM bonds, many concede, are indeed risky.
“The way to get higher returns is to turn to the emerging markets,” says Wharton finance professor Richard Marston, speaking of equities. The simple reason, he says: The EM countries have a lot more room to grow than the developed ones.
In fact, many EM stocks are trading at extremely attractive price-to-earnings multiples of less than 10 to 1, adds associate Amy Huang, who is responsible for emerging and frontier-market investing at Morgan Creek Capital Management LLC, an investment adviser and management firm for institutions and wealthy families.
“The way to get higher returns is to turn to the emerging markets.” –Richard Marston
“Right now, it is a very good time to buy emerging markets, given that the [Standard & Poor’s 500] is at an all-time high,” Huang says, cautioning that events could change her view, which, she adds, does not necessarily reflect her firm’s. Huang is especially keen on the “frontier markets (FM),” composed of countries like Vietnam, Bangladesh and Saudi Arabia, that are less developed than the well-known EM countries like China, India and Russia.
“We view the frontier markets as emerging markets 2.0,” Huang says. “If you liked the emerging markets 10 years ago, you will like frontier markets today.”
The Sword of Damocles
What, then, is causing all the pessimism?
Investor confidence was hit hard in May when Federal Reserve chairman Ben Bernanke indicated the Fed’s $85 billion-per-month bond-buying program would soon start winding down, a process others dubbed “tapering.” That program has been geared towards boosting the U.S. economy by keeping long-term interest rates low. The low rates led many investors to move capital to riskier EM markets offering higher returns. If the Fed started to unwind the program, many thought, the capital flow would reverse, undermining prices of EM securities as demand declined.
That fear became a self-fulfilling prophecy. Shares in the iShares MSCI Emerging Markets Index fund, an exchange-traded fund tracking EM stocks, fell from around $44 in early May to less than $37 in late June, a nearly 17% drop in six weeks. Most of those losses were recovered after the Fed indicated in September that tapering would not begin for some time, but the index has had big ups and downs, reflecting investors’ jitters. Many worry that the actual start of tapering will again undermine EM holdings, so that an inevitable bloodbath merely received a stay of execution, not a pardon. “Fed policy is a Sword of Damocles for emerging markets,” Patrick Legland, head of global research at Societe Generale, wrote in a recent note to investors.
“There is a renewed awareness of the vulnerability of the emerging markets to monetary conditions in the industrial countries,” Marston says, noting that this is probably a good development, reducing the impulse of “dumb money” to follow fads.
Huang argues that all the worry about tapering, and the rise in U.S. interest rates that would eventually follow, misses the point. Tapering will begin only if the Fed believes the U.S. economy is strengthening, and stronger economies in the developed world will increase demand for products and commodities produced by the emerging countries. “If there is growth in the Western world – in the U.S. and Europe – who will benefit? The U.S. will benefit, and the emerging markets will also benefit.”
While the developed and emerging economies are clearly linked, they do not necessarily march in lock step all the time, notes Kent Smetters, professor of business economics and public policy at Wharton. He points out that this kind of non-correlation is just what investors are after when they diversify their portfolios: When stocks in developed companies zig, those in emerging markets may zag — not always, but sometimes, helping to dampen a portfolio’s ups and downs.
The emerging markets and frontier markets “represent a diversification play against some of the large inflationary pressures that will soon exist in the U.S. and EU.” –Kent Smetters
“To be sure, many EM countries heavily export to U.S. and [European Union] markets, and so the EM countries are dependent on the U.S. and EU economies,” he says. “But a lot of EM production, and especially [frontier market] production, is also consumed locally and in other parts of the world.”
He also argues that EM and FM countries generally do not have the long-term government debt issues that infect the U.S. and many other developed countries. “Because most EM and FM countries have had less credibility historically with debt markets, these countries simply carry less government debt, especially implicit debt in the form of entitlement programs that are creating enormous budgetary pressures in the U.S. and EU. The EM and FM markets, therefore, represent a diversification play against some of the large inflationary pressures that will soon exist in the U.S. and EU.”
The other rap on emerging markets is that the easy money made by exporting goods and natural resources to the developed countries has already been made. To maintain a rapid pace of growth and big stock market returns, companies in these countries must sell products and services to domestic consumers, not just foreigners. Some analysts feel this change is too slow to make investing in EM stocks attractive now.
“What we see in many emerging economies, speaking broadly, is that the current model of growth is becoming exhausted, which has been, in many of these emerging economies, export-led,” says Wharton management professor Mauro F. Guillen, speaking in a recent K@W podcast. “So we’ve seen very little progress in most of these countries — China, India, Brazil — in terms of the development of a domestic market that would compensate for slower growth in terms of exports. There’s been some progress, but not enough to essentially keep the economy going at a very fast pace, which is what happened throughout the last few years.”
Huang suggests that demographic factors, such as relatively young populations and expanding middle classes, make emerging markets attractive in the long run. In addition, she notes, it’s a mistake to see the emerging markets as one big asset class. “The question is not ‘in or out?’ It’s ‘which country, which sector, which stock?’”
Today, the cheapest EM stocks are very cheap by historical standards, while the most expensive are unusually expensive, she says. Many big consumer-oriented companies in China, for example, are indeed trading at premium prices and are not attractive at the moment. Many of those are “H” stocks traded in Hong Kong. They are relatively easy for Westerners to buy, so they have been the choice of those who want EM holdings but are a bit nervous: Nervous investors go to familiar names. However, she adds, many Chinese consumer-related “A” stocks, traded in mainland exchanges, are still available at attractively low price-to-earnings multiples.
The Fragile Five
A group of companies dubbed the “Fragile Five” — Brazil, Indonesia, India, Turkey and South Africa – have been the focus of worries over issues like currency volatility, rising labor costs, and poor export and economic growth. But Huang notes that a turnaround is nonetheless possible, especially as all five have elections looming. “If these countries rally, they will rally at a very large magnitude.”
Currency risks are often cited as a major issue with EM investing and, indeed, have been a source of volatility this year in some countries.
For similar reasons, the EM subset of frontier countries still has big growth potential. That list, different depending on who comprises it, generally includes about 25 countries ranging from Argentina, Bangladesh and Kenya to Lithuania, Nigeria, Tunisia and Vietnam. Many of these countries have not been heavily researched by investment analysts, enhancing the odds of finding bargains, Marston says.
Of course, many EM countries still contain the extra layers of risk long associated with the developing world: political turmoil, corruption, lack of effective financial regulation and transparency, and thin trading that makes buying and selling difficult and contributes to wide price swings.
Guillen notes that the potential trigger of tapering “comes at a very bad moment, when there is also political turmoil in several of these countries, including, most recently, street protests in Brazil. There’s rising income inequality, which also adds to the problems. And, more broadly, there are bubbles. There’s clearly a real estate bubble in several of the markets in Brazil. There’s clearly a real estate bubble in several areas in China, or perhaps all over the country, and so on.”
In some EM countries, banks are experiencing growing numbers of bad loans, he adds, noting also that slow growth in developed countries depresses the export growth that emerging markets need if they can’t crank up domestic consumer demand. Among the major EM countries, Guillen worries the most about Brazil, China and India, believing Russia is a bit more solid because of strong exports and vast natural resources.
Currency risks are often cited as a major issue with EM investing, and, indeed, have been a source of volatility this year for stocks in India and some countries.
Huang says, however, that over the past 15 years, the basket of EM currencies has returned an average of 6% a year in U.S. dollar terms. So, although fluctuating exchange rates can indeed be a problem for the short-term speculator, they actually boost returns over the long term.
So the real risk is in seeing the emerging markets as one big block rather than as a myriad of opportunities, some good and some not worth the risk. If there is an exception to this rule, it is with EM debt. This year has seen a surge of bond offerings by EM companies eager to grab investor cash hunting for yields. Some of that new debt offered yields upwards of 7%, roughly three times what investors can earn on 10-year U.S. Treasuries. Marston believes a lot of dumb money chased after yields by pouring into emerging markets indiscriminately. A rise in yields in U.S. Treasuries and other comparatively safe alternatives could cause money to flood out of EM debt, causing prices to crater.
And because opportunities in EM markets are so diverse and difficult to fathom, Marston believes investors should pay for active investment management rather than relying on the fire-and-forget index-fund strategy that has worked well for investing in U.S. stocks. Given a variety of factors, from slow economic growth to looming debt issues, stocks in the developed countries are not likely to continue to match the high returns of the past, Marston says, making emerging market investments all the more attractive. For a typical American investor, he suggests, about 40% of the stock holdings should be in non-U.S. firms, with half of that portion earmarked for emerging markets.
“I think investors ought to be allocating more to emerging markets than they have in the past.”