VALUATIONS LOOKING ATTRACTIVE IN EMERGING MARKETS.
Astrong U. S. dollar has generally been bad news for emerging markets in the past, but we’re six years into the current bull run for the greenback and the picture is looking a lot different.
If 2016 i s an accurate guide, emerging market currencies can still do well in a strong dollar environment — and even outperform the global reserve currency, as they did last year.
One primary reason is valuation, with Phil Langham, London- based portfolio manager at RBC Global Asset Management, pointing out that EM currencies collapsed in the five years prior to 2016.
“Valuations on a number of different measures look extremely cheap, and are near the lowest levels they tend to get to on measures such as purchasing power parity,” the portfolio manager of the $ 2.7 billion RBC Emerging Markets Equity Fund said during a recent visit to Toronto.
Langham thinks most of the recent dollar strength has been driven by developed market currency weakness, rather than softness in EM currencies. That includes DM currencies such as the Japanese yen, euro and British pound — regions where monetary policy remains extremely loose.
Outside of the currency market, Langham noted that EM fundamentals are improving in areas like current account balances. Deficits in place four or five years ago have turned into surpluses, growth is improving, EMs have relatively high real rates, and countries have stronger foreign exchange reserves.
All this helped emerging markets perform well in 2016, although the election of Donald Trump triggered a brief but meaningful sell-off late in the year.
Langham, who heads up the RBC GAM’s emerging market equity team that also runs a dividend and a small cap strategy, believes the pullback was driven by three factors: renewed dollar strength, rising bond yields, and fears of protectionism.
EM equities have since resumed their outperformance, as relative growth has improved along with profitability.
In 2011, EMs were growing at a rate of about five per cent faster than DMs, but that number dipped to roughly two per cent in 2015. EM growth has begun to accelerate again, and that improvement in growth historically translates into better relative performance.
As far as profitability, Langham noted that EM return on equity dipped substantially in the past four or five years — from approximately 15 per cent to closer to 11 per cent.
“There are signs that is starting to stabilize,” the portfolio manager said. “The key driver for that fall in ROE was a drop in margins, but there has been an improvement in productivity, capacity utilization, and we’ve seen lower capex and production taken out in some areas.”
The resulting improvement in margins is expected to f l ow t hrough to better profitability, and then stronger earnings.
It ’s also i mportant to understand that while there still is correlation between EMs and commodity prices, particularly for Latin America and South Africa, for example, that correlation has come down dramatically in recent years.
Langham noted that commodities used to represent more than 35 per cent of the benchmark MSCI Emerging Markets Index, but that number fell to 13 per cent by the end of 2016.
“Emerging markets used to be seen as a way of playing commodities, but that has very much changed as consumer sectors now represent a larger part of the index,” he said.
That is quite a big difference with what has occurred in Canada, where energy and materials still account for more than 30 per cent of the S&P/TSX Composite index.
The emergence of EM consumers is hard to ignore, but with so many choices for investors, Langham is focus- ing on the opportunity presented by large numbers of people entering the middle class.
“It’s at these income levels that consumption really takes off, as people stop spending money just on necessities,” he said, adding that in lower-end economies, that may mean more stapletype goods like toothpaste, and in more advanced economies, things like smartphones.
On a regional basis, Langham’s favourite long- term opportunity is in India, where GDP per capita remains very low, so penetration in many areas still has a long way to go.
“From a bottom- up point of view, India looks very attractive, but it’s also starting to look much better from the top down,” he said.
Despite the severe economic slowdown and stock market hit t riggered by reformist Prime Minister Narendra Modi’s demonetization efforts, Langham thinks the pain won’t be prolonged.
He is c onfident t hat growth will start to normalize in urban areas within a few months, and thinks investors need to remember this is all part of needed reforms.
“The aim was to effectively cut back on the black money ( underground economy), and that is likely to be one of the long-term rewards of this policy,” Langham said.