Can the emerging market bull run continue?
While some developing countries stand to benefit from long-term and sustained structural gains arising from China's overseas expansion, others are merely proxies for crude industrial demand
Emerging-market equities have outperformed their counterparts in the developed world by a wide margin so far this year, with the benchmark MSCI gauge gaining 12% vs 4% for the S&P 500 and Germany’s DAX index. EM equities have played Charlie-Brown-and-the-football with investors on too many occasions to inspire comfort, though.
On a 10-year horizon, the performance of emerging markets has been miserable. Investors who began with US$100 at the end of 2007 would have US$160 if they bought the S&P 500, but the MSCI Emerging Markets Index would have yielded just half that return. In that light, this year’s performance feels like it could be just another dead-cat bounce by EM stocks.
Investors should also bear in mind that some emerging markets are proxies for the global demand for commodities. Brazil was the world’s best-performing large stock market during the past 12 months, but from an investing perspective, Brazil is an iron ore mine masquerading as a country. The US dollar price of Brazilian stocks (reflected in the MSCI Brazil Index and the ETF ticker EWZ) has tracked the iron ore price closely during the past five years.
There is one common thread across the diversity of emerging markets, and that is China. Soaring Chinese demand raised the price of iron ore and other commodities. There is a reasonably close correlation between China’s manufacturing PMI and the price of industrial metals.
Of greater interest, though, is China’s outreach to neighboring economies through its US$100 billion One Belt, One Road infrastructure development program, one of the most ambitious undertakings in economic history. This stands to benefit economies from Turkey to Thailand, although in quite different ways.
With the construction of high-speed rail between Thailand and China, Thailand is likely to become China’s truck farm and a provider of high-value-added food exports.
Thailand has resisted the Chinese model of forced urbanization, and the rail link allows Thai farmers to sell high-end products to Chinese consumers and deliver them fresh to Southern China. Thailand’s beaches will become a weekend excursion for Chinese tourists only a few hours away on high-speed trains. The impact will be transformational.
Turkey stands at the transportation node between China and Europe, and the construction of rail links across Central Asia will soon reduce the travel time by train from Beijing to Istanbul from four weeks to 10-12 days. China will be able to pack components into containers, ship them to Anatolia for assembly, and send the finished products on to Europe and Africa.
Vietnam is the recipient of US$56 billion in Chinese foreign direct investment in nearly 4,800 projects. Now that the cost of Chinese labor is approaching Southern European levels, Vietnam has become a source of affordable and reliable labor for Chinese manufacturers.
The Philippines’ main mobile provider Globe Telecom engaged China’s premier equipment manufacturer Huawei to build a 5G network throughout the archipelago, a revolutionary change in what has been a lagging economy. Globe’s stock price has risen 30% since December 2016.
To oversimplify, Asian emerging markets are a play on productivity gains stemming from improved transport and communications, while Latin American emerging markets are broadly a commodity play. That is not entirely the case, to be sure.
Auto parts are more important than oil to the Mexican economy, and the politics of trade with the new Trump administration will remain the dominant theme in that market.
Emerging markets for the most part are much cheaper than developed markets. Korea, China and Turkey trade at less than 10 times estimated forward earnings, compared with 16 times for the S&P 500. There are exceptions: the Indian market seems pricey. So does the Philippines, although the impact of China’s growth makes the Philippines interesting.
The emerging markets are cheap because they have performed poorly, because their political stability is questionable and their corporate governance recalls Mark Twain’s definition of a gold mine: A hole in the ground with a bunch of liars standing around it.
Korea and Taiwan strictly speaking are not emerging at all, but rather recently emerged. South Korea has suffered from a strategic risk premium due to the dangerous behavior of its northern antipode, as well as the recent misfortunes of Samsung, which comprises 23% of the MSCI South Korea Index. Taiwan depends on a single industry, namely semiconductors, and faces increasing competition from China.
Nonetheless, world economic trends are likely to buoy the underperformers for the remainder of 2017. The cold wind of deflation has died down, China has come out of its industrial recession, and world trade seems likely to rise after two years of stagnation.
It seems unlikely that the EM Index will recoup its massive underperformance against the S&P, but some narrowing of the gap seems a reasonable expectation. EM outperformance during the first quarter is likely to be a harbinger of better performance than developed markets for the rest of the year.