As the U.S. equity market soared in 2014, rising 13.69%, the MSCI Emerging Markets Index was the mouse that didn’t roar. It squeaked in at minus 1.82%.
This year, however the emerging markets index was already up more than 10% by May, proving again that this is a space with a hair-trigger temper, where hot money flows in and pushes up currencies (and vice versa), largely through indexes and ETFs. But hot money can also burn you. The Institute of International Finance says that non-resident emerging markets funds fell from a high of $1.35 trillion in 2013 to $1.1 trillion in 2014, mainly because of political turmoil in Russia.
Yet long-term emerging market growth rates are hard to ignore. Citibank has said that 70% of global growth will come from emerging market countries in the future.
When non-resident money flows in, local currencies improve. Consumer confidence in these countries soars. People buy more fast food, insurance and health care.
But then there’s a temper tantrum—a whisper about the end of quantitative easing is on Fedsters’ lips in the U.S., which spooks investors, making them fear that emerging market countries’ U.S. debt will suddenly become too expensive. Money moves out. Currencies turn white. Inflation scares local consumers and the vicious cycle proceeds apace.
But a lot of that might stem from the false sense that the emerging market space is monolithic.
The recent plunge in oil and commodity prices and more reform-minded governments in countries like India might be the crack in the façade, says Teresa Kong, a portfolio manager at Matthews Asia. Those importing cheap raw materials like oil, copper, nickel and iron ore now have a distinct advantage over those that are yanking the stuff out of the ground. Many Asian countries that use cheap raw materials and resell them as value-added material goods to an emerging middle class might be set to decouple from the Latin American and Eastern European countries.
Observers say that the demand over the last decade for added capacity to produce raw goods for huge developing economies like China’s has finally paid off and led to commodities’ cheapening. That’s an important structural sea change for the emerging markets.
“The commodities super-cycle has arguably played itself out to a large extent,” Kong says. “Commodity prices not only in oil but across the metals, across agricultural goods, have come down substantially, and if you look at the areas of the world that are really going to benefit most from this, it’s going to be Asia. And the areas of the world that are going to suffer the most are going to be, to generalize, Latin America and Russia, which are by and large commodity extractors who are selling these to grow.”
Bill Greiner, the chief investment strategist at Mariner Wealth in Leawood, Kan., says that his firm is emphasizing Asian countries for the same reasons, and he believes they will outperform South American ones over the next year (he said in April). Mariner has liked the iShares MSCI All Country Asia Ex-Japan (AAXJ), for some time. It excludes Australia and includes China. “Forty-one percent of the ETF is invested in China and Hong Kong and the other 59% is outside Hong Kong and in the other Asian Tigers. This fund has done extraordinarily well over the last year or so since we’ve owned it. … Frankly, we’re looking for an entry spot to add more of the fund to our clients’ portfolios.”
Paul Attwood, the portfolio manager of the Huntington Global Select Fund, is also banking on the themes of net energy importers thriving. More than half the constituents of the MSCI Emerging Markets index are net importers of energy—Attwood calculates 70%. He adds that governments of these countries will benefit because they have been subsidizing energy for consumers. Now that oil prices have come down by almost half since last year, those countries can now put that money to work serving their debt rather than paying for gas—“countries like Malaysia, India, Indonesia. A lot of those countries are running current account deficits,” Attwood says.
He has been building positions in his fund based on this theme. He likes Taiwan and South Korea for being among the biggest net importers in the group. “That’s fed straight into the economy, straight into the consumer; it increases discretionary spending,” Attwood says. He’s leaning toward consumer discretionary and staples, and also manufacturing, which will benefit from lower energy costs.
Buck, Buck, Buck
But many investors in EM have turned chicken because of the threat of QE tapering off and the dollar rising. The latter could create the dreaded vicious cycle for those countries that have to pay back too much expensive U.S. dollar-denominated debt.
But Deborah Vélez Medenica, a New York-based portfolio manager at Fred Alger Management’s Alger Emerging Markets fund (AAEMX), says the currency situation and the effect of the rising dollar is more complex than people give it credit for.
“The answer is not always as black and white as commentators would have you think. … The emerging world is not necessarily as tied to the U.S. dollar as it was 20 years ago. Countries have grown up, if you will; they have a lot more [strength] at their central bank and finance ministries. We have a lot more instruments in the world for central bankers to use in the space of currency.”
For the most part, emerging market countries have been reining in their external debt and foreign financing and living a more pious, less leveraged life. The same can’t be said of corporations in these countries, many of which are increasing their leverage. Greiner recently wrote a piece for the site “Seeking Alpha,” noting that the MSCI Emerging Markets Index has a debt-to-equity ratio of 71% now, which is up from 52% a decade ago. If the dollar continues to bulk up, that debt will be harder to refinance and heavier to bear. “You have to really understand company balance sheets now,” he said to Financial Advisor.
Bets In Low Places
Perhaps the most unloved countries in the emerging markets space are Turkey, Russia and Brazil. Turkey suffers from high current account deficits and a perceived inability of its central bank to fight inflation. Russia has suffered for its dependence on declining oil and increasing international sanctions since its interference in Ukraine. Brazil has also suffered from high account deficits, oil dependence and the Petrobras scandal, in which dozens of politicians have been enmeshed in charges of bribes and kickbacks related to the state oil company.
And yet Frederick Jiang and Jonas Krumplys, portfolio managers with the $600 million Ivy Emerging Markets Equity fund (a Waddell & Reed affiliate whose ticker symbol is IPOAX), say they are actually overweight in all the BRIC countries, including Brazil and Russia.
World dynamics being what they are, Brazil and Russia still hold appeal if you’re looking at stocks on the ground, they say. The Ivy fund has even gone to a slight overweight in Russia, partly because inflation has likely peaked at 16.5% and Russian stocks, after being mangled in 2014, looked like a flea market of good bargains as investors headed into the New Year.
“We don’t think Russia is a long-term structural winner,” says Krumplys, “but the economy seems to have bottomed, so psychologically investors are anticipating that six to nine months from now they’ll be doing better.” Also, the country has foreign reserves, not deficits. And despite Brazil’s Petrobras scandal, the president has put in a finance minister trying to do fiscal reform, Krumplys says.
Riad Younes, a portfolio manager at R Squared Capital Management’s $50 million RSQ International Equity Fund (RSQVX), says he’s added to Russia because it’s so cheap it’s a nice short-term tactical trading opportunity. The firm has 1.75% exposure to the country, purely through a country ETF as a tactical macro trade, though he says those seeking individual stocks might feel confident in a growing Russian food retailer like Magnit, which he calls very transparent and well run.
David Ruff and his team at the Forward Select EM Dividend Fund, which has $45 million, focuses on companies with high dividend yields and likely earnings growth, which allow for dividend growth and price appreciation. “Oftentimes you find the lower multiples in the challenged macro areas,” he says. The firm looks for a company’s dividend history relative to its local market and then applies statistics to tell him when it’s unusually high. That has led the fund to such names in Brazil as Ambev, the beverage company; the stock exchange BM&F Bovespa; and Hypermarcas, a Brazilian pharmaceutical concern. These companies have been offering excess cash generation.
In Russia, Forward has positions in what he calls good payers: Norilsk Nickel, the nickel/palladium producer, and mobile phone operator Mobile Telesystems.
The Forward EM dividend, launched in the middle of 2011, came about because the team was looking over its much larger broad international dividend strategy and found that emerging markets players seemed to be doing particularly well with dividends.
“Oftentimes, we find better dividend payers and dividend policies in small caps,” says Ruff, “which sounds a little bit surprising because these are smaller companies—they want to grow and they should be saving their capital to grow. … But what happens is lots of times these are families businesses that go public, and the family or founder or majority stakeholder retains control of 50% or more or the company, and they will many times pay themselves a dividend. We like those kinds of situations, because we’re seated on the same side of the table.”
The high dividend payout proves the company is well-disciplined in a wild west emerging markets world.
Two other names he likes are 8990 Holdings in the Philippines, a low-cost prefab residential builder which is benefiting from lower construction costs in a country with great housing demand, and Globetronics, a Malaysian company that provides LED chips and sensors for phone handsets, among other things.
He says the fund has outperformed the MSCI Emerging Markets index since inception, but the taper tantrum upset the apple cart. His fund lost 6.78% in 2014.
Oil, Not Oil
The effects of oil on the emerging markets might have some investors sanguine.
But Medenica says the effect of plunging oil prices on the Asian countries has been overstated—nobody expects oil to stay cheap forever or to keep giving companies a boost. Instead, she says, countries like India, which she favors, are likely to benefit from many of the same fundamentals China has, including long term increases in per capita income growth.
“India’s move has been much less [than China’s], but even to get part of that achievement over the next five to seven years you’re looking at a very significant increase in per capita income, which will translate into higher unit volume growth or changing dynamics in companies, which is something … you’ll begin to see in a couple of calendar years not necessarily this calendar year.
She thinks the underreported area is the Andean markets in Latin America like Colombia, Chile and Peru, which are written off as commodities exporters but are actually more complex, taking off in things like food retailers, banking, IT and health care. “We’ve been able to find for the last few years with interesting growth profiles and hence we tend to be always overweight those markets.”
Kong, who leads the $70 million Matthews Asia Strategic Income fund (MAINX), says, “The biggest trend we’re seeing is the fact that wage growth has outpaced GDP growth for the last 10 years. I was visiting China two weeks ago and we continue to track 10% to 15% wage growth on an annualized basis.
“What’s interesting is that even blue collar workers have been seeing this type of wage growth. In fact, there’s been a dearth of blue collar workers. So this wage growth you’re seeing has in fact driven the production further west to western parts of China as well as places like Vietnam, places like Sri Lanka, Bangladesh. They look to benefit from basically the rising costs of wages in China.” Because labor is becoming a scarcer resource, automation is skyrocketing. “I go to China once a year,” Kong continues. “No longer do you see someone sweeping the floors in any of these commercial buildings. You see older women who are using these machines, like they do in New York City.”