Emerging markets to rebound

The Intelligent Investor James Carlisle

The reopening of the Chinese economy will help to support the rebound of emerging markets in 2023, according to the US investment manager Federated Hermes. It says emerging market growth will be supported by rebounds in South Korea, Taiwan and Brazil and stabilisation in India, Indonesia and Mexico.

In 2022, emerging markets underperformed developed markets due to the China lockdown. But if China is stripped out, emerging markets performed in line with the developed world.

Kunjal Gala, the head of global emerging markets at Federated Hermes, says he expects to see emerging markets bounce back in 2023 due to the China factor.

“In addition to trough valuation and light investor positioning, the growth differential between emerging and developed markets is set to expand on the back of favourable demographics, manufacturing capabilities and availability of critical resources,” he says.

Gala says China is at a critical juncture, with equities 25% cheaper than the historical average of the index, but potentially it is time to forget about historical valuations. The debt-fuelled model that drove China’s growth in the past is irrelevant, and it is now time to focus on how the country is likely to evolve beyond the re-opening.

“We believe that China is unlikely to grow annually at more than 6%-6.5% in real GDP terms and a mid to low single-digit outcome is feasible,” he says. “Beyond the issues at the surface, the Chinese economy is undergoing a more profound transformation that presents unique investment opportunities for long-term investors.”

Considering the full emerging market, Federated Hermes forecasts a shift in the investment environment that will be decisively different from the past decade.

Underpinning this shift is higher-than-normal inflation and cost of capital, alongside supply constraints with energy, commodities and labour. “While developed economies are learning to adjust to inflation, emerging economies have a golden opportunity to improve their competitiveness,” he says.

Years of covering Telstra’s results have demonstrated one thing clearly: Australia’s largest telco is a mediocre business.

Returns on equity, in the low double digits, are acceptable only by piling on debt. Unlevered returns on capital are piddling; we doubt they have covered Telstra’s cost of capital for a decade.

It’s astonishing to think that $16 billion of debt and $15 billion of equity have been harnessed to generate such low returns. The business itself is targeting returns on capital of just 8% over time.

The mobile business accounts for over half of operating profits. Another 25% of profits come from the towers (assets that Telstra leases to itself) and from asset leases to the NBN. The rest, including a shrinking enterprise segment, a low-margin broadband business and a decent, if small, international arm, is an insignificant distraction.

The mobile business continues to impress. In the first half of the year, margins rose to 43%.

The issue is that the other projects don’t make sense or money. This should be a smaller, simpler business with better returns.

Since we upgraded the stock two years ago, the share price is up over a third and generous dividends have been paid.

But that journey is coming to an end. Until Telstra rids itself of the non-performing divisions, we have no desire to be long-term shareholders.

James Carlisle is a senior analyst at Intelligent Investor