Pragmatism in a revolutionary world: The case for emerging market antifragility

Key takeaways
The case for emerging markets
Pragmatism
Investing in EM over the long term
The case for emerging markets is compelling. Emerging markets (EM) are positioned differently in this global downturn compared to those in the past. Balance sheets at the government and corporate levels are far healthier than in previous crises. EM central banks are ahead of the curve in dealing with inflation, having begun their tightening cycles earlier than the developed world. And in a world with elevated energy prices, resource-rich countries (Brazil and Chile) are benefitting, while net importers of commodities (China and India) are securing long-term supply contracts at discounted prices funded in their own currencies.
Yet, emerging market valuations are at steeper discounts to the developed world than the preceding decade. Emerging markets are evolving from being a beta play on global growth to a potential source of alpha generation in a rapidly changing and uncertain world. The net result is an opportunity to own undervalued, high-quality names with the potential for long-term structural growth.
Emerging market performance
EM equities, currencies, and bonds are holding up better than developed markets in 2022
Despite the tough downturn across markets in 2022, emerging markets have outperformed their developed markets peers. The MSCI Emerging Markets Index is down 17% on the year, while the Global MSCI ACWI Index is down 19%, and the S&P 500 Index is off 20%. Meanwhile, the MSCI EM ex-Russia Index is down just 14% during the same period.1
Likewise, emerging market currencies have outperformed their non-US developed market counterparts, having lost 2.0% year to date against the US dollar while the euro, pound, and yen have all fared far worse.
Finally, emerging market bonds, down 16.5% year to date, have outperformed non-US developed market government bonds (EU sovereign debt is down 19.3%), while only marginally underperforming US corporate debt (down 14.6%).2
This is a far cry from past global crises and downturns when emerging markets routinely fared worse than developed markets across asset classes. History suggests that as a beta play on global growth, emerging market asset prices and economies come under siege in times of crises.
Typically, in the past during times of stress, emerging market currencies have come under assault given fragile current account deficits, equity price declines, and elevated levels of foreign ownership of emerging market debt being indiscriminately sold. This has translated into a deeper depression of asset prices and broader underperformance versus developed market equities, wreaking havoc on both businesses and valuations. However, the situation today is different.
Source: Bloomberg
Figure 1 displays the MSCI EM Index and the MSCI ACWI Index from October 2007 to October 2008. In previous market downturns, EM assets have historically been hit harder, as demonstrated above in the 2007-2008 Global Financial Crisis.
Source: Bloomberg
Figure 2 displays even amidst a flight to the dollar, EM currencies have dramatically outperformed developed market currencies. This graph displays a comparison between the J.P. Morgan Emerging Markets FX Index, the euro, the pound, and the yen, all against the dollar.
Source: Bloomberg. The indices used in the above graph are the S&P Eurozone Sovereign Bond Total Return Index, the S&P Japan Bond Index, and the Bloomberg EM USD Aggregate Total Return Index.
Figure 3 displays that emerging market bonds have outperformed broader developed markets bonds (in dollar terms), unlike past global downturns and crises. This owes to broadly stronger balance sheets and general financial indicators.
Emerging markets have no major structural imbalances
Unlike previous periods of duress, emerging market economies now exhibit healthier balances of payments and balance sheets with no significant external and internal imbalances. EM health is reflected by steady current account to GDP ratios, and modest asset price and credit growth. Our team believes that this has contributed to asset price stability despite broader economic headwinds. In many economies, the local share of ownership of domestic debt continues to increase, contributing to broader stability in both debt and currency markets.
Source: World Bank, as of date and date of retrieval is 6/27/22.
Figure 4 represents the most recent data available from this source and displays the current account balances of Brazil, Mexico, China, India, Indonesia, South Africa and South Korea. Current account represents the balance of financial inflow as well as outflow for goods and services. This forms a portion of a country's balance of payments. When you compare current account to GDP (gross domestic profit), it frames a comparable ratio that can be contrasted against other countries. A positive figure implies that a country is a net exporter of goods and services, and a negative figure implies that a country is a net importer of goods and services.
Emerging market central banks are ahead of the curve
While Western central banks continue their battle to tame inflation, many emerging markets are nearing the peak of their hiking cycle — having taken earlier moves to counter the commodity-led inflation wave.
As inflation pressures normalize throughout the coming months as energy price pressure starts to ease, elevated nominal rates will translate into unnecessarily high real interest rates. This in turn may provide EM central banks ample breathing room to reduce rates, encouraging economic growth and lifting asset prices.
Source: EM Advisors
*EM countries included are: Brazil, Bulgaria, China, Colombia, Croatia, HK, Hungary, Indonesia, Israel, Korea, Malaysia, Peru, Poland, Saudi Arabia, South Africa, Taiwan, Thailand.
Figure 5 displays that at this moment emerging markets do not display noticeable asset bubbles, unlike their developing markets counterpart in the US.
As of April 30, 2022. Source: EM Advisors. Index is created by EM Advisors, measured by local private credit claims against their respective nominal GDP growth across 40 emerging countries.
Figure 6 displays a ratio of credit growth against GDP growth in emerging markets. It displays that unlike previous crises, emerging market credit growth is more moderated, contributing to broader economic stability.
The impact of higher commodity prices and geopolitical uncertainty
In a world that increasingly shuns Russian energy, resource-rich emerging market economies such as Brazil and Chile — among the largest non-OPEC producers — should see tremendous benefit to their balance of payments and government revenue as countries politically align themselves. Those countries who chose not to — namely China and India — may be in a position to secure long-term energy contracts at discounted prices and funded with local currency, thereby accelerating their economic growth through discounted industrialization.
Emerging market equities are very, very cheap
The key takeaway from all these factors is that emerging markets look very attractive today on a valuation basis. The MSCI Emerging Markets Index trades at an 11.2 trailing 12 months price-to-earnings ratio (P/E) and 8.4 trailing 12 months enterprise value to earnings before interest, taxes, depreciation, and amortization ratio (EV/EBITDA), compared with 16.0 and 10.9 for the MSCI ACWI Index, respectively, and 19.1 and 13.1 for the S&P 500 Index.3 These represent steeper discounts to their developed market peers than the preceding decade despite healthier fiscal and monetary positions for many emerging markets exiting the pandemic.
*TTM – Trailing Twelve Month
Source: Bloomberg, as of 06/27/2022
Figure 7 displays that emerging market assets are trading at a discount to broader developed markets assets. ACWI index represents global performance of large- and mid-cap stocks. Emerging market valuations - represented in the ratios on the graph - are at, or close to, all time high discounts compared to their developed markets counterparts.
Emerging market pragmatism in revolutionary times
We live in revolutionary times
The following forces collectively represent considerable headwinds to equity prices globally, adversely influencing growth, earnings, and discount rates.
- The regime shift from 40 years of disinflation to structurally higher inflation will have the profound impact of higher cost of equity, driven partially by structurally higher resource prices.
- The great energy transition and decarbonization agenda, driven by the rise of environmental, social, and governance (ESG) investing.
- A significant increase in capital intensity after 30 years of growth driven by the deflationary forces of technology and globalization.
- The return of geopolitical stress as economic, military, and cultural power has become more diffused.
- Deep social and political fractures are emerging across the world as a result of inequality. Policies designed to address these deep fractures and geopolitical stress will likely create a very different world than the recent past.
The dominant narrative in markets today is around adverse cyclical developments: inflation, the energy crisis, US Federal Reserve rate hikes, a strong US dollar, and geopolitics. Ultimately, investors are going to see that the narrative of the past 30 years will not be the narrative of the future. We are potentially entering a world where many of the revolutionary forces just mentioned will dominate the investment landscape.
Emerging market resistance to a “new world order” and rejecting the “cashmere curtain”
Beyond inflation, the other significant risk that investors need to become accustomed to, compared with the past 40 years, is the return of geopolitics. The unipolar order that emerged with the fall of the Iron Curtain is over. Power — be it security, economic, or cultural — has become increasingly diffused, and the resulting tensions are leading us towards a highly uncertain world order.
Broadly, the response of the developing world to the twin challenges of structurally higher inflation and geopolitical tension is one of pragmatism. While the West appears to be fabricating a new “cashmere curtain” around Russian resources, many countries in the Southern Hemisphere are increasingly suspicious of such oversimplified demarcations.
In short, the Southern Hemisphere is mistrustful of perceived hypocrisy in the reunited West. This includes policies around vaccines (hoarding), immigration, decarbonization and the energy transition, the weaponization of finance and muscular sanctions, trade wars and export controls, and perceived cynicism around recent efforts to repeal sanctions placed on “bad actors” like Iran and Venezuela.
In some respects, the Southern Hemisphere is realigning to an informal “non-aligned” group oriented towards balancing long-term aspirations (decarbonization) with the realities of economic development and poverty alleviation.
Large emerging market countries are both uniformly against the Ukraine invasion, while broadly realistic about Russian resources. They are balancing realism around the energy crisis with steadfast support towards multilateral cooperation on existential threats such as climate change, security, nuclear proliferation, and the economic issues of competition, trade, investment, and prosperity.
Russian resources remain critical to global development (and prosperity)
The world cannot live without Russian resources, period. Disincentives — shaped by ESG and climate change mandates — have already restrained much-needed investment in hydrocarbons and thermal coal. The goal of decarbonizing the global economy will take many decades and this long (and difficult) energy transition will require significant fresh investment in energy and base materials.
Russia is home to 20% of global proven natural gas reserves and supplies 40% of the EU’s natural gas demands. Russia also has the world’s largest reserves of nickel and second-largest gold reserves — not to mention copper, palladium, thermal coal, steel, and aluminum. Emerging economies realize a world without Russian resources would be both grim and unrealistic.
This puts countries willing to pursue a degree of revisionism and embrace pragmatism in a position of great strength — or antifragility — as they enter long-term contracts at steep discounts in local currencies, securing their energy needs for decades to come. For nations like India and China, who import 86% and 73% of their oil and 55% and 43% of their natural gas, respectively, this may afford them a unique opportunity to mitigate the pressures of elevated commodity prices.4
Conclusion: The case for pragmatism
Many emerging market countries face increasing resource demands as their economies grow and develop, and yet their per capita consumption levels pale in relation to the developed world. Indonesia and India are illustrative, with just 11.2% and 8.7%, respectively, of primary energy consumption per capita compared to the United States.5
Source: BP Statistical Review of World Energy 2021, pg. 13
Figure 8 displays that primary energy comprises commercially traded fuels, including modern renewables used to generate electricity. Energy from all sources of non-fossil power generation is accounted for on an input-equivalent basis.
These are large, relatively poor populations that see their contributions to climate change as marginal relative to the developed world. Perhaps appropriately, their priorities are economic and social development. The twin effects of inflated commodity prices — providing economic security for resource-rich countries, like Brazil and Chile, and long-term discounted supply for the net importers like China and India — will likely help to underwrite economic growth.
With disciplined central banks, strong balance sheets, and a pragmatic approach in the new world order, emerging economies are now positioned to shed their label of fragility.
Higher commodity prices are here to stay and structural in nature. Much of this is associated with the (very) long energy transition ahead, which requires considerable physical investment in new infrastructure, renewable generation capacity and enormous EV battery capacity. After a decade of considerable earnings (and share price) pain, mining company boards are only just beginning to contemplate growth again. However, given resource nationalism, elevated environmental and social challenges to new projects, and political risks across resource endowed geographies (Peru, Chile, Central Africa, Central Asia/Russia), it is difficult to envision where the copper, cobalt, and nickel are going to come from.
Markets are facing structurally improved demand and structurally challenged supply. But as we hope we have illustrated, this is, on balance, a positive for emerging economies. Emerging markets may be evolving from being a beta play on global growth to a potential source of alpha generation in a rapidly changing and uncertain world.
While macro and geopolitical headwinds have created a significant performance challenge in the past year, we believe that the portfolio is well-positioned for a shift to an environment where long-term fundamental company analysis and idiosyncratic stock selection is once again at the forefront. We are long-term investors in extraordinary companies and spend our time doing deep and differentiated research to identify sources of structural growth, the durability of competitive advantages, and real options that could play out over time.
The indiscriminate sell-off in 2022 gives us opportunities to invest in many great businesses at very attractive prices in many of the areas that we have historically been able to generate alpha — consumer discretionary, technology, financial services, health care, and, increasingly, resources. As we get back out on the road to meet with companies, we are energized by the potential of these investment opportunities to generate considerable long-term value for clients.
Footnotes
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1
Source: Bloomberg, as of 6/29/2022
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2
Source: Bloomberg, as of 6/29/2022
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3
Source: Bloomberg, as of 6/29/2022
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4
Source: BP Statistical Review of World Energy, 2021, pg. 18-23.
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5
Source: BP Statistical Review of World Energy, 2021, pg. 13.