Hugh Young, Managing Director, Aberdeen Asset Management Asia Limited
Donald Trump's first weeks as U.S. president are turning out to be just as controversial as his election campaign. A flurry of executive orders on border controls, trade and healthcare has dominated headlines, caused dismay among some and even galvanized some opposition.
The drama that seems to be unfolding on a daily basis makes the modest comeback that developing markets have been enjoying all the more surprising. The MSCI Emerging Markets index has risen more than 4% since the U.S. election in November 2016, even though it fell nearly 5% that month, in part, on fears that Trump's policies could challenge global trade.
What has caused this change of heart? U.S. stocks have given global markets a helping hand, with the Dow Jones Industrial Average Index crossing 20,0001 for the first time. Investors are hoping that looser regulations, including the possible repeal of the Dodd-Frank Act, will help beleaguered companies. In particular, banks.
But flows to emerging market equities, excluding China A-shares,2 turned positive last month after outflows in November and December, suggesting interest in the asset class has its own merits too.
Across the emerging markets, corporate profitability has been improving. Net income margins for non-financial companies surpassed those of their counterparts in the developed world last year. Emerging market return-on-equity, another measure of profitability, is higher than the return of equity (ROE) of European and Japanese companies.
Higher profitability has been helped by a recovery in commodity prices, amid a modest pick-up in global trade that has shown up in stronger exports. Lower capital expenditure has also freed up cash flow to the benefit of balance sheets and, possibly, dividends.
The upturn is partly cyclical, following years of corporate discipline. The measure of this opportunity is evident in asset allocations and valuations: global equity vehicles' asset-weighted average exposure to emerging markets has fallen to some 8.5%, from a 10-year high of around 16.5% at the start of 2012. Emerging market equities are trading at some 1.5 times book value, almost 16% below the 10-year average.
Part of the problem is that investors see a world divided between "safe" developed markets and "risky" emerging markets. Following the shock results of last June's Brexit vote and the U.S. election, this distinction may need a reappraisal.
Almost a decade after the U.S. sub-prime mortgage crisis, the country's debt has grown around 33% to more than $45 trillion. Some members of the European Union (NYSEARCA:EU) are still one bailout away from going broke. Japan's flagging economy defies all short-term fixes.
Meanwhile, the world's fastest growing major economy is India. It's a country making progress on business-friendly reforms. China, where domestic consumption accounts for around half the economy, has managed to restore stability, even though concerns linger. Elsewhere, prospects for Brazil and Russia - emerging markets that have been battered in recent years - are also looking up on higher commodity prices.
Developing economies, on the whole, are in much better shape than they were even a few years ago. Economic and monetary policies are largely orthodox and paying off. Inflation is under control, or falling, so that central banks have room to cut interest rates to support growth. Their best companies have become experts at overcoming adversity.
If these frenetic first weeks of Trump's presidency are a glimpse of what is to come - policymaking on the hoof, conflict over compromise, ego over evidence - then emerging markets are entering uncharted waters. Heightened uncertainty will make them vulnerable to further shocks - either from China, the U.S. Federal Reserve (Fed) or other potential flashpoints.
A trade war with China could hurt both countries. Higher government spending, despite lower tax revenues, can lead to a wider fiscal deficit.
Protectionism, one of Trump's major goals, is likely to fuel inflation in the U.S. by making goods more expensive. U.S. companies will then become less competitive, and eventually, U.S. growth could slow.
One of Trump's advisers coined the term "alternative facts" while defending the White House's disputed assessment of the number of people that attended his inauguration. In a world where truth is subjective and orthodoxies are being overturned, emerging markets manage to look quite well grounded.
1. Since this article was originally published the Dow Jones has since broken through 21,000.
2. A shares: A-shares are 'onshore' shares in mainland China-based companies that trade on the Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange
Additional disclosure: ndices are unmanaged and have been provided for comparison purposes only. No Fees or expenses are reflected. You cannot invest directly in an index.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.
A version of this article originally appeared in Money Marketing on February 17, 2017.