Q&A with Kim Catechis, Head of Emerging Markets at Martin Currie, a Legg Mason affiliate.
Q: Are emerging markets (EMs) still attractive, given their performance last year?
A: Very much, yes. EM had a great 12 months, delivering 25% to end of March and looking forward, in terms of valuation and what you get for your buck by investing in EMs, we are looking at ROEs of 12.2 percent and climbing, versus 11.8 percent and going flat in developed. On the price-to-book side of the equation, it’s a big, yawning gap. EMs with a higher-end climbing ROE are priced at 1.8 times book relative to developed world, which is priced at 2.3 times book. On the technical side, this asset class has been completely transformed. Ten years ago, it was 34 percent commodity-driven; now the technology sector is about 28 percent of the index. (Commodities now account for 14%) Hence, the aggregate debt burden carried by the index is a lot lower, and aggregate ROE is a lot higher.
Two countries that are quite strong are Russia and Brazil. Both are coming out of recessions, and their strongest performers have been energy and financials: clearly reacting to the appreciation of oil prices. In most emerging markets there is strong, sustainable GDP growth accelerating the natural trend towards urbanization. The growth of the middle-income population in these countries, backed up by strong demographics, accelerates demand for services and creates opportunities for investments.
Source: MSCI EM, MSCI World, Bloomberg, USD as at 31 March 2018
Q: Why should U.S. investors, who have done very well in their home markets, consider EMs?
A: It has been perfectly justifiable for U.S. investors to stay long with the S&P 500 over the last five to seven years. Going forward, we are looking at peak valuations and peak profitability. Increased number of U.S. companies are buying back shares and retiring them as a way of propping up their valuations. It’s just looking very unsustainable.
As investors consider the potential to maximize savings, valuations are important. EM countries currently provide strong investment themes that could play out over the next two, three, four decades. A long-term investment horizon could help mitigate the relatively higher volatility that EM countries have historically had.
Q: Could the “trade war” initiated by U.S. President Donald J. Trump be to emerging markets’ advantage?
A: The threatened U.S. tariffs on steel and aluminum imports have gone live, although up to two thirds of imports are exempted. But President Trump has announced plans for charges on up to $60 billion of Chinese products, sparking concerns of a trade war.
Beijing has already dug in for the long haul and is unlikely to back down. China is accelerating diversification of markets via its Belt & Road project and other initiatives. Its modest response has been to target mainly agricultural goods, a sensitive sector for U.S. exports. There are further measures waiting in the wings in the event of any further escalation.
The perceived wisdom is that President Trump has left room to concede, and China has targeted an increase in oil and soy imports. This could offer a face-saving de-escalation.
While these headlines may have caused alarm among investors, in the longer term, these trade restrictions will only serve to accelerate the rapid growth of intra-regional trade among EMs, to the exclusion of the U.S. - further shifting the axis of world trade in emerging markets’ favor.
Q: How are the potential U.S. policy changes affecting these markets?
A: Dominating talk for a while has been the proposed U.S. steel tariffs, but there is no great impact. It does however create expectations that we may get a second leg, then a third, and then a fourth.
The European Union and others have been preparing commensurate, proportionate ways to start showing their displeasure, whilst at the same time opening formal complaints at the World Trade Organization (WTO). In the emerging markets, nothing changes short-term. However, if this heralds a more aggressive U.S. stance on trade and tariffs, then the risks are up everywhere.
Gary Cohn’s departure was a signal. Perhaps he and the globalization free trade people in the White House have lost the argument. Much will depend on who replaces him. Most of the names we have seen mentioned are probably acceptable, except for Peter Navarro.
In April, the U.S. Treasury Department will issue a six-month report on foreign exchange markets. That will give them the opportunity to label countries currency manipulators. We would not be surprised to see some Asian countries on that list. The last time it was South Korea and Thailand. China was not named last time around, but potentially could be, this time. That presumably would be good enough reason to trigger extra tariffs or other measures on those nations.
By August, the U.S. also likely will issue a report on Chinese intellectual property practices. We expect a negative or C-minus-type report, which likewise could be used as an excuse to maybe go a step further. This is our position at the moment. If nothing happens other than tit-for-tat, which we are used to seeing, Harley Davidsons will get more expensive in Europe. I am happy because I bought my last one, a Road King, in December. I do not need to change it for a while.
Q: What about the Trans-Pacific Partnership (TPP)? Will that create opportunities?
A: Many countries are signing wide-ranging trade deals. The TPP that the U.S. stepped out of pretty quickly last year is being signed by the other 11 countries; they are carrying on regardless. If other countries get used to dealing with the U.S. without trading on good terms, they will start to think of it as the normal practice. TPP includes a lot of traditional U.S. allies such as Japan, Australia and New Zealand. The proposed 10-nation Regional Comprehensive Economic Partnership (RCEP) being pushed by China includes India, South Korea, Japan and Australia.
Those countries are going to continue the increasing volume of trade between them. It probably will accelerate the trend of EM-to-EM trade, at the expense of trade with developed countries.
Q: There seems to be more volatility in the market. How are you thinking about that?
A: We are long term holders who seek to invest in companies in the high-quality end of the market. Factors we seek, such as robust balance sheets and solid business can help individual companies weather volatility better. ESG assessments can also help us identify good-quality managements. We deliberately pick companies that are undervalued for their ability to keep delivering good cash flow growth over the three-to-five-year horizon.
Switches in the market – in terms of increased volatility – can sometimes throw up opportunities, particularly for investors with a long-term time horizon. Ours is primarily a slow and steady approach in terms of the types of companies we go for.
Kim Catechis is the Head of Emerging Markets at Martin Currie, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
©2018 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.