The writer is head of global emerging markets at the international business of Federated Hermes
For long-term investors in emerging markets, the current phase in the global economic crisis has echoes of the past. It is not their first rodeo when it comes to dealing with scarred markets recovering from a crisis.
Previous cycles are instructive in how emerging markets react to broader trends and how cheaper value stocks within that equity universe trade compared with more pricey growth shares. Value stocks — such as more cyclical companies — tend to outperform coming out of a crisis. However, in the longer term, quality growth has won out.
The 1997 Asian financial crisis, triggered by a currency crash in Thailand and at which I had a ringside seat, seemed to herald the end of the region’s growth. With contagion still raging, the Russian debt crisis erupted and seemed to announce the chaos of a failing state. In 1997, the emerging-markets benchmark collapsed almost 57 per cent. But it recovered by February 2005.
Value stocks underperformed growth companies by about 27 per cent in the 36 months to March 2000, when fear was ascendant. The tables then turned decisively: value outperformed by 65 per cent from March 2000 to December 2008. China’s entry into the World Trade Organization created unprecedented demand for raw materials. These crises abated with support from the developed world and its multilateral institutions. The pattern held until 2008.
On September 15 of that year, when Lehman Brothers was allowed to fail, I watched as bids vanished from my screen and share prices of the world’s best companies dived into the abyss. This time, the developed world caused the strife. In a clear debunking of the theory that developing economies had decoupled from more developed counterparts, emerging markets fell by about 61 per cent and took 36 months to recover. In this period, value edged ahead of growth by about 5.7 per cent.
But it has since been vanquished: from January 2012 to date, growth has outperformed by about 80 per cent. The so-called “taper tantrum”, when rising US bond yields spooked the more fragile emerging markets, encouraged investors to look for less cyclical investments and they jumped on Alibaba’s initial public offering, and fast-growing social networks.
Most big emerging economies went into the 2008 financial crisis with current accounts and foreign-exchange reserves in surplus and dollar liabilities better matched with dollar assets than in the past. There were notable exceptions, but it was evident that the emerging world was maturing.
China, in conjunction with the world’s central banks, stimulated enough demand to resurrect the global markets and economy. In subsequent years, structural changes in many emerging economies — from economic liberalisation in China to digitisation across the board — showed that the “emerging” label was outdated.
In emerging markets and the S&P 500 alike, intellectual property has become the new quality investment. Companies with such assets outnumber those surviving from earlier days. Energy and materials companies in the MSCI Emerging Markets Index have shrunk from 37 per cent before the financial crisis to less than 10 per cent now. The technology sector currently commands the same benchmark weighting in emerging markets as in its S&P 500 counterpart of more than 30 per cent.
There are sound reasons to invest now, especially on a cyclical basis. Indicators of economic activity such as purchasing managers’ indices are recovering, the threat of trade wars with the US has faded and the export and the tourism sectors should bounce back as vaccines are distributed. An Asian free-trade zone is on the horizon, building on the Regional Comprehensive Economic Partnership.
Investment metrics also tell an attractive story. Emerging markets trade at a 20 per cent discount to developed ones on a sector-adjusted basis, close to a 20-year low. A weaker dollar should allow emerging-market currencies to appreciate, along with equity markets, buoyed by relief on a collective $5.2tn debt burden. A lower dollar would also benefit commodity exporters.
But investors should temper their enthusiasm for 2021 with the knowledge that debt levels, demographics and investment for a more sustainable economic system may constrain profits over the medium term.
Slower macroeconomic expansion will ensure that quality growth retains a premium. In the short term, value will have its day in the sun. But for investors with a longer time horizon, quality will remain king.
Get alerts on Emerging market investing when a new story is published