20th April 2013
Emerging markets have long been flagged as the great white hope for the global economy. Not only were they going to drag debt-laden Western economies out of recession, they were going to make investors rich in the process. That hasn’t happened, with the IMA Global Emerging Markets sector one of the worst performing over the past few years. Money continues to pour into the sector, but can its popularity last in the face of this weakness asks financial journalist Cherry Reynard.
The average global emerging market fund is up 4% since 1 January. Investors may be grateful just to make money, but they would have been far better off in North America, where the average fund rose 18.8% or Japan, where the average fund rose 23.7%.The performance of the BRIC -specific sectors has been even worse. The average China/Greater China fund is up just 3.5%, while Russian and Latin American funds have also fared badly. It is a theme recently picked up in trade paper Money Marketing.
Where did it all go wrong for the BRIC economies? The first problem, according to Matthew Vaight, manager of the M&G Global Emerging Markets fund, was the starting point. He suggests that valuations in the Chinese stock market in 2008 implied earnings growth of 28%. In hindsight, that was bubble territory and investors were ignoring the fundamental growth characteristics of Chinese companies.
Equally, too many people made the mistake of linking GDP growth and stock market growth. The assumption for many investors was that there would be a clear link between high economic growth and stock market returns. This has not proved to be the case. As Vaight points out, “it’s not about GDP growth. It’s about value, governance and returns, but people still think there is a linear relationship between economic growth and stock market returns. GDP growth is only ever a tailwind. China has had fantastic GDP growth and the average Chinese citizen is much wealthier, but the topline growth has not translated into earnings for Chinese companies.”
He believes that the problem for many emerging market countries has been poor return on capital in many state-dominated emerging market countries. Companies are run for the state or minority interests rather than for shareholders. This can be seen in the relative performance companies operating in emerging markets with state dominance and those without. He points out that the average South African company has a return on capital of 11%, while the average Russian company has a return on capital of just 5% and concludes: “The Russian corporate sector systematically destroys value.”
Equally, while it may not preclude stock market growth, the economic backdrop in the major emerging markets has also weakened, removing any tailwind it might once have provided. Earlier this week the Chinese Government announced a surprise slowdown in growth to 7.7% – Wall Street Journal reports. It said that manufacturing had been sluggish and consumer economy was developing too slowly to compensate for this weakness. The FT explored the issue of emerging market consumers a little more in its blogs.
Dan Tubbs, a global emerging markets portfolio manager at Mirabaud, says: “The BRIC markets can be characterised as suffering from slowing economic growth and rising underlying inflation, which may lead to tightening monetary policy, while policy in developed markets remains loose. China was the worst performing BRIC market in the first quarter. The newly appointed government reiterated measures to cool the property market, which is a core part of the Chinese economy. In India, political instability continues after the already weak coalition lost support a key member. In South America, Brazil has been hit by growth dramatically slowing to just 0.9% in 2012, despite significant monetary stimulus, and unprecedented levels of government interference in most major industries. Finally in Russia, the economy has slowed to just 2.1% in 2012 due to a combination of weaker consumer spending and a deceleration in investment activity.”
That is a bleak assessment. And while it could be argued that global emerging markets are not solely the BRIC economies, together the BRICs account for over 40% of the GEM universe. Also, other countries have now become more expensive. Vaight highlights Thailand, which has made leaps and bounds in improving corporate governance in recent years, but its progress has been well-recognised by markets and is fully reflected in valuations.
The question for investors is whether these markets have suffered enough and are now likely to improve. The negative economic news emerging from China still provides a headwind, and countries such as Brazil are still dependent to some extent on Chinese demand for commodities, but valuations across the BRIC markets are certainly more compelling. Vaight points out that Chinese markets are now implying earnings growth of just 4%. Whatever the structural economic problems of these countries, it is reflected in the price. Vaight says that valuations have compelled him to look once again at the BRIC economies.
Fund flows into emerging markets have also continued to be strong, suggesting that institutional investors do not believe that the story is over in emerging markets. European investors directed €1.46bn to global emerging market funds during the month, according to data from Morningstar. This should be supportive for the asset class as a whole.
It has been a difficult time for investors in emerging markets. The promised riches have not materialised. However, valuations are now at sensible levels and while there remain problems in the BRIC economies, this alone should support stronger relative returns from here.