Emerging Markets: A Compelling Value Opportunity?

Posted by Alex Frey (@alexhfrey )

Emerging markets have a conundrum for investors. In the first decade of this century, EM markets were high-flying with the BRICs (Brazil, Russia, India, and China) all the talk of the finance world. As always, as soon as people starting talking about the importance of international diversification, it was US stocks that started out-performing, and emerging-markets stocks caught a cold, badly out-performing most of this up-cycle despite their reputation as a "high beta play" (which should tend to go up more than US stocks when things are good, and down more when they are not). 

Last August, we wrote a newsletter about this. We noted that emerging market (EM) stocks were much cheaper than U.S. stocks by most measures and that EM economies were also growing faster than the U.S. economy.  High growth + cheaper seemed a good combination. Also, after a long period of no gain, EM stocks were showing strong gains, and in 2017, the gains on EM stocks exceeded those on the S&P 500. High growth + cheaper + positive momentum seemed an even better combination. 

While we stopped short of making any predictions, you might have thought that things were setting up nicely for EM outperformance. But now, that trend has reversed. As shown in Figure 1, the performance of EM stocks has turned south while U.S. stocks have mostly recovered from their turbulence earlier this year. So, what has caused this reversal?

It's always good to start with the fundamentals. In this case, these don't seem to have changed much. Table 1 shows the average dividend yield and average price earnings ratio on the Vanguard FSTE Emerging Markets Exchange Traded Fund (stock symbol, VWO) and the Vanguard Total Stock Market (U.S.) Index ETF (VTI). By these valuation measures, the EM fund is much cheaper. Figure 2 shows the average growth rate of gross domestic product (GDP) for EM countries and developed countries as computed by the International Monetary Fund. In recent years, and at present, the EM economies have been growing more rapidly. The real (inflation adjusted) U.S. growth rate in 2017 was 2.3%, in line with other developed countries and well below the average emerging markets growth rate.

fig1.png Figure 1: The performance of VWO (emerging markets) and VTI (total U.S. market) for the past 2.5 years. Data is from Vanguard.

fig2.png Table 1: Dividend yield and price earnings ratio for VTI (U.S. stocks) and VWO (emerging market stocks). Data is from Morningstar.com

fignew.png Figure 3: Growth of GDP for EM and advanced countries. Data was taken from the International Monetary Fund Data Mapper.

So what’s wrong with emerging market stocks? Growing debt in EM countries could be a problem, but emerging market debt is still well below the debt levels in developed countries (see Figure 4). Nevertheless, EM debt is growing, and this may be part of the problem. A related problem is the turn around in the value of the dollar. As shown in Figure 5, in 2017 the dollar had been declining in value, but now the trend has turned, and in recent months the index has been growing in value. Some (but much less than half) of the EM debt is denominated in dollars. As the dollar increases in value, it becomes harder for EM countries to pay interest and principal. It also means that profits earned in EM countries are reduced when they are expressed in terms of dollars.

The change in trend for the dollar has been driven in part by the increase in interest rates in the U.S. This attracts dollars to the U.S., since they can get a higher interest, and of course it adds to financing costs in the U.S. and elsewhere.

Another factor is the decline in the “current account” of EM countries. The current account measures how much a country sells abroad (including goods and services) minus how much it buys. If the current account is positive, countries have funds that they can use to invest elsewhere. If it is negative, they need to attract foreign capital to meet their domestic investment needs. As shown in Figure 6, the current account of the EM countries had been strongly positive, but it has now dropped to a small negative sum. This is could mean that they might have trouble in paying foreign investors, but their current account balance is still far better than that of the U.S.

Figure 4: Total debt in EM and advanced countries. Total debt includes household, corporate, and government. Data is from the Global Debt Monitor Database.

fig5.png Figure 5: The dollar index (a measure of the value of the dollar on foreign exchange markets). Data is from the Federal Reserve System.

Figure 6: Current account balance of advanced and emerging market economies.

Of course, the tariffs announced by Trump are almost certainly another reason for the turn in EM stock values. While China was the biggest direct target of these tariffs, the EM countries (which include China) tend to be strongly dependent on trade, and other EM countries tend to be quite dependent on trade with China. Table 2 shows how the importance of trade to the economies of various countries. Any interruption in world trade is likely to have adverse effects on EM countries.

fig7.png Table 2: Trade as a percent of GDP for various countries. Data if from the IMF Data Mapper.

Of course the term "emerging markets" is a bit of an investing invention of convenience. In reality, EM markets are a collection of individual countries, each of which has idiosyncratic factors that influence the way it's companies are valued. A few notable markets have been going through governing turbulence that may be impacting this. Turkey is a leading case in point. Turkey has a significant budget deficit (about 2.7% of GDP), very high inflation (currently about 15% per year and increasing). Normally, a central bank would counteract inflation by raising interest rates, but Turkish president Erdogan has said that he is going to oppose any attempts to raise rates. Turkey also has a rather large current account deficit, about 5.5% of GDP, which may make it difficult to pay foreign creditors and attract needed investment capital. The Turkish lira has been dropping rapidly in foreign exchange markets. Erdogan, who seems to be rather ignorant of economics, has established something close to autocratic power in Turkey. From an economic perspective, runaway inflation seems to be a real possibility, and default on debts denominated in currencies other than Turkish lira are also possible.

Argentina is another worrisome case. Argentina has historically had trouble maintaining good fiscal discipline and bouts of extreme inflation have been common. The current administration seems to be serious about maintaining fiscal discipline, but they are paying a price for the prolificacy of their predecessors. Inflation is currently running at about 30% per year, the current account deficit is about 4.8% of GDP, and the government primary budget deficit is 3.5% of GDP. The International Monetary Fund (IMF) predicts that all of these measures will improve in the next few years, but the present situation is worrisome.

Brazil is also a problem. The country has severe political problems. Its last president (Rousseff) was impeached for fiscal mismanagement, and the one before her (da Silva) was recently convicted of corruption charges. The current budget deficit is 6.5% of GDP, and current inflation is about 4.4% per year and has been increasing. It remains to be seen whether Brazil will have the political will to solve the budget and inflation problems.

So should investors pull out of emerging markets? We don’t think so. The emerging market countries are a diverse group. There is clearly risk in EM stocks, but relatively low valuations give hope for rewards as well. With the potential for much higher growth rates than in the already-developed West, and valuations that are lower as well, emerging markets still seem compelling over the long-term, on balance. As always, we believe that diversity is the key, and we think that maintaining a small commitment to EM stocks is a good idea.

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By Alex Frey