Why We're Bullish on Emerging Markets

Year to date, emerging market equities have continued their strong performance, with the MSCI Emerging Markets NR Index up 17.01% (CAD) (as at July 31, 2017). In fact, as markets continue to improve, so does our certainty that the lows seen in January/February 2016 represent the end of a lengthy bear market for EMs, and the start of a long-term bull market in the asset class.


Emerging Market Bull and Bear Market Price Levels

Source: Somerset Capital Management, Bloomberg L.P.


Three factors underpin this view

  1. From a price perspective, it is difficult (though not impossible) to envisage markets falling below the January/February 2016 levels. At that time, EMs were wrestling with the collapse in oil prices as well as an earnings recession – both of which have seen improvement since.
  2. We believe the global capital cycle has either turned or is turning:
    a. We are seeing a significant shift in the global consensus from austerity, in the years following the financial crisis, to Neo‐Keynesian. On both the left and right side of politics, governments are now talking about spending more to generate growth.
    b. Many emerging economies have also hit a turning point in terms of interest-rate cycles. For example, Brazilian interest rates peaked at 14% in 2015/2016, with rates since falling to a current 9% – a significant change and shift in direction.
  3. From a stock-selection perspective, there are simply longer lists of companies that seem interesting now because the valuations are right. More fundamentally, we have started to see a turnaround in returns on capital from particular sectors and potentially in certain countries. A good example of this is the oil sector; it is reasonably clear to us that returns on capital in the oil sector have bottomed out and are probably turning around. We have gone from a period in 2010‐2014, where returns on capital were very high, to a collapse, and now, stability. Bottom line, we think that there is a greater chance that they are rising than falling.

Where are we seeing potential?

Russia: Improving Fundamentals despite Sanctions

Russia has shifted in terms of its economic outlook because of a change in its central bank policy since 2014. This has resulted in what we now believe is a relatively stable banking sector, something that will underpin the economy and the reflation of the economy. There has also been strong wage deflation in the Russian market in the last two or three years – another move in the right direction.


Korea – Positive Trend in Corporate Governance

Although there are some wider foreign policy issues that we have less of a strong sense of, we are increasingly positive on the corporate governance situation in Korea. One of the complaints about Korea over the last 10‐15 years is that it is never going to be on the same safe P/E valuation as a proper developed market – or other emerging market – because corporate governance is so bad. The incumbent political party has been part of the problem, as it allowed Chaebols, or large corporate conglomerates, to do things that aren’t in the interest of minority shareholders. However, incumbent president Park Geun-hye was recently impeached and arrested under allegations of taking bribes. We believe this will be a major catalyst and lead to a rerating of the Korean market.

 Adoption of Stewardship Code
Actively Considering: Mirae Asset Global Investments

Public Officials Benefit Association

Positively Considering: KB Asset Management

Korea Teachers’ Credit Union

Military Mutual Aid Association

Carefully Considering: Samsung Investment Trust Management

Hanwha Asset Management

Korea Investment Management

Source: Korea Investment & Securities Europe Ltd

India – High Growth, but High Valuations

We are also quite interested in India, although it is often difficult to find really good value stocks there. That being said, we are willing to pay up for exposure to Indian growth; the bull market period from 2004‐2007 for India was consistently quite expensive, but had you avoided the market then, you would have missed out on some very interesting opportunities.

In addition, Prime Minister Narendra Modi’s recent demonetization initiative appears to have gone very well for him. Although the maneuver hasn’t had the effect on growth that it probably ought to have had, it has allowed Modi to consolidate power, even though it may end up hitting his own voter base more than those who oppose him (e.g., the working class shop owners). This is the area that demonetization has hurt, yet when you speak to people on the ground, they are really in favour of what Modi has done because they perceive it as hitting both corruption and the powerful elements in society.

China Still a Risk

A potential Chinese banking or capital crisis is certainly a risk to our thesis. However, one of the problems is guessing at what the government’s and regulators’ policy response is going to be, because China has many different policy choices that would likely lead to different outcomes. For instance, to control capital flows, the government could opt to:

• Raise interest rates, which might have a worse effect on the banking sector in the short term but stem capital flows.
• Increase restrictions on capital flows, which might have more of a knock-on effect on trade.
• Devalue the currency as they did in 1994, which might impact inflation.

The truth is, they are seemingly able to do a bit of everything and nothing completely. For the moment, that has left the situation seemingly benign. The question is, can they genuinely engineer the soft landing?

It is still really hard to know or give any definitive answer to that. What happened in 2015 is just not the sign of healthy market. Within a year, there was a stock market bubble, where the market – particularly in Shenzhen – raced upwards and then collapsed when the regulator changed margin accounts. Now we arguably have the same thing going on in the property market; it’s not a healthy situation.

In terms of the knock-on effect on emerging markets as a whole, we believe we are in a very different situation than we would have been in three years ago, which is partly due to the change in the global capital cycle. For example, when interest rates in Brazil were at 7% rather than at 14% and falling – that is a point in time when Brazil would have been intensely vulnerable to problems in China. This doesn’t mean Brazil or other emerging markets are now going to be immune to a fall out in the Chinese banking system, but they appear to be in a much better place.



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