Heading Abroad - Why Emerging Markets will outperform the S&P 500
Following on from my two most recent articles regarding currencies and investment environments, I felt it was a good time to write an article on Emerging Markets (EMs), since this is a topic I have not covered and I do not have much exposure to the asset in The Spark’s portfolio (yet). So, in this article I will discuss:
· What Emerging Markets are and how they relate to my previous articles
· When to buy and when to avoid EMs
· Why they look attractive compared to developed markets
· Risk factors when investing in such a region
If you haven’t already, please read my articles on currencies and risk on/risk-off environments, as this is foundational to understanding emerging markets.
Frontier… Emerging… Developed
Generally speaking, there are four types of economy in the world – Less Developed, Frontier, Emerging, and Developed. A Less Developed Country (LDC) is one where global trade and income per capita are low, poverty rates are high, and there is likely to be corruption in government. North Korea and Afghanistan would be examples of this. As we move to Frontier, Emerging and finally Developed countries, the level of technological development, amount of international trade, the strength of the local currency, and the other factors mentioned above improve significantly.
Emerging Markets are well established compared to those lower down the chain, but lag developed markets due to factors such as lower household income and less mature capital markets. Since the early 2000s, the big five EMs were Brazil, Russia, India, China, and South Africa – known as the BRICS. These countries have experienced rapid growth in infrastructure development and share of global trade. Although China is the second-largest world power today, because of its income inequality it’s still classified as emerging.
Since the outbreak of the Ukraine-Russia war, we have discovered just how important each of these EMs is to world trade. Russia’s sanctions have hurt oil markets. Due to Ukraine’s inability to export wheat, India needed to step up, but has now held back supply to feed its own people. The COVID lockdowns in China are causing a slowdown in global growth and its property crisis has led to a roll-over in commodities recently.
Long-term opportunity
Both Frontier and Emerging Markets are attractive to many investors because they present a better long-term opportunity than in developed nations. Such countries experience faster growth in GDP compared to developed countries as they increase their global network and use capital to upgrade infrastructure, improve the standard of living and increase the population’s wealth.
Vietnam GDP Growth is significantly higher than UK GDP Growth, Source: The Spark
As well as faster growth, EMs have better demographics than western nations. They have a younger population and as such countries healthcare improves, people live longer too. This means EMs have faster growth and ever-improving productivity in their economies. This is compared to countries like the UK and US, which have an increasing elderly population, which reduces productivity, increases debt burdens due to pension payments, and leads to reduced consumption (elderly people tend to spend less than the working population). All these issues point to slower growth for western nations.
For these reasons, many established companies are investing heavily in EMs. This makes sense because as an EMs infrastructure improves, more jobs are created, people become better educated and income rises. They live longer and have higher disposable income meaning they spend more on discretionary goods like smartphones. This is one reason Airtel Africa is held in The Spark’s portfolio, as the technological and demographic trends in Africa are very attractive as the population becomes increasingly wealthy. It is no wonder Google has committed $1bn to upgrading digital infrastructure in Africa.
Nigeria internet penetration is growing exponentially, Source: Statista
Sell on the first sign of blood
Building on my two previous articles noted above, EMs are generally a risk-on asset class. Therefore they thrive when investors’ risk appetite increases and they seek a higher yield/better returns. This means EMs do well when global credit is flowing and there is little uncertainty in the world. Because many EMs are large commodity exporters, it’s good to buy them when the global economy is performing strongly. The US Dollar is also a major factor dictating the returns in these regions (more below). 2020/21 was a good period for many EMs like China, who until the property crisis and tech crackdown produced great returns for investors.
EMs also do well when the US Dollar is weaker. Because many EM currencies are weak and not trusted by investors, both governments and corporations in EMs would issue bonds denominated in US Dollars rather than their local currency. This is because an EM cannot print US Dollars (unlike their local currency) to pay off the bond repayments. Due to this, when the US Dollar strengthens the EM’s local currency will weaken, meaning it will cost an EM country/business more to repay its US Dollar bond to investors. This inevitably leads to less money in the company/country’s pocket, and so less capital to spend on improving the business or region. Also, in times of uncertainty there is usually a ‘flight to safety’, where investors ditch riskier, higher-yielding assets for the security of more assured assets. This usually leads to a double-whammy for EMs, where investors ditch foreign currency for the US Dollar (strengthening it), but also ditch EM assets leading to significant price falls.
On top of this, many EMs like Brazil depend heavily on commodity exports to drive GDP. A weaker US Dollar usually benefits countries importing commodities (as commodities are priced in USD), which in turn benefits EMs. This is observed in the graph below, as “Doctor Copper” tends to rise when the US Dollar falls. Dr. Copper gets its name because the Copper price is generally a great proxy for the state of the global economy. When it is rising, this usually means the US Dollar is weaker, global trade is booming through infrastructure development, and credit/liquidity is flowing smoothly. Through the second half of 2021, we can see the USD rising, and Copper has now begun to turn lower - this may be pointing to tougher times ahead.
US Dollar (Orange) and Copper price (Blue), Source: TradingView
Countries to look out for
China is a leading world power and continues to challenge the US in every way. It is developing its capital markets and technological innovation strong. Despite the issues regarding the property market in China over the short-medium term, the crisis should help with the long-term growth of China. The rules which led to a crash in the property market included limits on the debt levels of property companies and requirements around liquidity. This meant many companies had to quickly delever, causing the crisis. Over the long run, this should lead to a less speculative housing market in China. Also, because the CCP and Xi Jinping is likely to be in control for many years, they can (and are) focusing on long-term growth over short-term political gains, in contrast to the west.
Chinese consumers spend ferociously when times are good, which should benefit companies such as Alibaba (NYSE: BABA) and Baidu (NASDAQ: BIDU). An example would be Chinese ‘Singles Day’, where Alibaba and JD recorded a record $139bn in sales on that day in 2021. For general exposure to the region, an investment trust you could research further is Fidelity China Special Situations (LSE: FCSS). For me, China is not investable due to its Variable Interest Entity (VIE – explained at the end of the article for anyone interested) structure. Also, the unpredictability of the actions of the CCP makes it difficult to assess risk to reward, and so I choose to avoid the region for the most part.
In my opinion, two attractive long-term investment opportunities are Africa and Vietnam. Both would be classified as Frontier Markets, but over the long term, I believe they will do well. Vietnam has property controls to prevent bubbles, a young and educated population, and should benefit from deglobalisation, as companies look to diversify manufacturing across many regions to prevent the reliance on one nation such as China for production. Africa also boasts a young and increasingly productive population and should benefit from continued investment in technology and infrastructure.
Not all sunshine and rainbows
Although the US Dollar has been strong over the last six months, many EMs have held up better than expected because of continued supply chain issues meaning higher commodities prices have sustained longer than they typically would in an economic slowdown. China is the biggest importer of commodities in the world, and due to the issues outlined above, demand for such materials has rolled over recently. This fall in demand is a leading indicator for a fall in commodities shortly after, part of the reason I sold my position in Anglo American (LSE: AAL) two weeks ago. The lack of demand means a market floor for metals prices created due to supply chain issues/ the war could fall from under it. Also, with 70% of Chinese household wealth in Real Estate, the negative wealth effect has led to reduced spending, as flagged by recent Chinese PMI numbers, which are now in contraction. The global economy is on a major cooldown.
Chinese demand has rolled over, commodities will follow, Source: Stenos Signals
During 2020, the flow of capital washing around the world meant everything in the market went up. The stock markets over the last six months have begun to reflect fundamentals rather than liquidity. However, over recent weeks it has now fallen without regard to fundamentals or valuation. In some cases, companies are still overvalued and others have become significantly undervalued. One example is Overstock, which is valued at $1.3bn with $500m in cash and a predicted $640m in estimated free cash flow by 2026. Its digital assets are worth over $1bn in my opinion and are priced at zero today. Due to the excessive move to the downside recently, I do expect a mean reversion with a significant move higher now. But I will not buy this dip, as the fundamental economic backdrop has not improved.
As discussed last week, we’re in a risk-off environment so this is not the time to buy EMs. Although the valuations of such regions are attractive, and the long-term opportunity is compelling, I wait patiently on the sideline for now. On a side note, my ‘Quality’ stocks are getting particularly expensive now, so I may look to reduce them sometime this week.
Portfolio Return Year-to-date: 2.8% vs S&P500: -13%
Total Return since inception (20/09/2021): 8.9% vs S&P500: -4.6%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
Peter
What is a Variable Interest Eentity?
A VIE is a structure set up to allow Chinese companies to list their stock in the USA. A VIE is a shell company set up with a written contract to say it’s entitled to the profits of the underlying business. Therefore, when you buy Alibaba stock, you are actually buying a VIE which has a contract with Alibaba, rather than buying stock in the company itself. The reason for this is that the Chinese Communist Party does not allow foreign investors to commit capital to its local market.
One issue with the VIE structure is that if the company goes bankrupt you have little to no protection. The second and more important issue is that the CCP has not allowed nor denied the VIE structure. Therefore, they could decide to ban them tomorrow and many investors would be left high and dry.
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.