What’s the difference between an emerging market and a developed market? We all know the answer to that. Emerging markets are fraught with political risk. Democracy is uncertain. There are endless elections and constant changes of government. You never know when what looks like a democratic decision might be overturned — or when a new government might mean a full on change of political direction.
Lobbyists and special interest groups reign supreme — think endless scraps about what rights particular industries, regions or races should or shouldn’t have. Corporate governance is ropey and taxation law uncertain: something can be deemed perfectly legal one day but be the subject of a skewed-looking court case the next. And of course, you can’t rely on populist governments of the sort that often turn up in, say Latin America, to be economically and socially rational or remotely interested in creating a business-friendly environment.
Add it all up and it is perfectly obvious that in order to account for the fact that you never know what an emerging market (EM) government is going to do next, EM equities should trade on a discount to developed market (DM) equities. That’s the case at the moment. EM equities have had a nasty decade so far: until this year they had underperformed DM equities every year since 2011 with last year being particularly trying (down 17 per cent in US dollar terms).
This year has been better: up 12 per cent so far. But still EM stock markets trade on an average price/earnings ratio of 12.4 times — a discount of about 25 per cent to DM stock markets. Quite right, you will say. All is as it should be. But I’m not so sure.
Look at the list of political risks above and (as you will have noticed on the way through) they are all risks in the west too. Spain looks to be on its way to a third election in a year. The EU is being torn apart by its failure to deal with its silly combination of joint monetary policy and separate fiscal policy, as well as its utter failure to deal with its migration crisis. Germany, which we all like to rely on for political stability in Europe, is coming to the end of its ability to force unity.
The UK has just voted to leave the EU. Apple has just discovered that “comfort letters” on tax matters means nothing when the tide turns against big business. Ireland is discovering that the limits to sovereignty imposed by EU membership actually matter. And the US is in the midst of choosing between two equally odd presidential candidates, both of whom appear to agree that protectionism is a perfectly good way forward for the US. Amid all of this, there is a shift away from globalisation, free movement (of production, capital and people) and a corresponding move toward pro-market policy.
Unless economic growth picks up in a hurry (and people feel it in their pockets fast) this isn’t going to change. The key point: until the financial crisis (and even for some years after it) political risk in the west was a one-way bet — one in favour of business and investors. That’s not the case any more.
And while the west is moving firmly in the wrong direction, much of the emerging world is moving in the right direction. EMs were always supposed to converge with DMs in the end of course: incomes were to equalise, institutions’ governance and transparency to improve and governments become more stable. That hasn’t exactly been happening at speed. But bit by bit, it is happening.
In Latin America, the likes of Chile, Peru, Columbia and Brazil are making the right noises, while in Asia there are standouts such as Vietnam and Indonesia. For now at least, says a note from Eurasia Group, there is a “positive inflection point in EM political stability”. But the convergence — and hence the argument for the disappearance of the EM discount isn’t just about politics (obviously). It is also about structural shifts in the economic make-up of various countries.
Thirty years ago, EMs were all about commodities and cyclical investments. No more. According to Ashmore Investment Management, some 50 per cent of the MSCI Emerging Market index is now made up of “structural growth drivers” such as telecoms, technology, consumer and healthcare companies. Overall, the tech share of the EM market is higher than that of the S&P 500 (23 per cent vs 21 per cent). The commodity component has fallen to a mere 14 per cent — less than half of what it was a decade ago.
The equity universe in EM is broader, deeper and hence much safer than investors think. That makes it too cheap. Structural growth companies “have superior earnings visibility for multiple years compared to cyclical ones”, says Ashmore, so investors should be paying up for them. One day they will. They might also soon be willing to pay up for income — the one thing you all tell me over and over again that you want more of.
Big companies in the west are close to the end of the dividend road: in the UK, 10 FTSE 100 stocks account for 55 per cent of the income — and their payout ratios are far too high for comfort. Across emerging markets, things are different. According to Invesco Perpetual there is a much higher degree of “dividend diversification” in the market (95 per cent of firms in the MSCI Asia Pacific ex Japan index pay out something) and with good earnings growth, robust cash flow, healthy balance sheets and payout ratios that are currently low, the most obvious direction for dividend payouts is up.
The gap between EM stocks and DM stocks doesn’t have to be closed by EM stocks rising — just as the gap in political stability isn’t just being closed by EM becoming more stable. Perhaps it will end up being all about overpriced equities in the US falling as wages rise and margins fall. Perhaps a wave of de-globalisation will push down all equities — just EM less than DM. But if over the long term we can agree that the two are converging in terms of their politics, their mix of sectors and their income generation we have to assume they will converge a bit more on valuations too.
If you want to be on the EM side of this, you can go for a cheap ETF such as the iShares MSCI Emerging Markets or a good trust such as the Pacific Assets Trust (which I hold myself).
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