In the last post in June, I concluded that ‘the ‘pain trade’ for global investors terrified of and positioned for a seemingly endless list of macro tail risks remains further risk asset performance in H2’ and so it has proven since. I’ve maintained a non-consensus overweight on EM equities and local currency debt all year, the latter helped by record DM portfolio inflows into the asset class as the pool of negative yielding bonds in Europe/Japan has surged to $12trn. GEM trades on just over 12 x forward multiple with 6.5% consensus earnings growth versus over 16x and just 0.6% for DM (adjusting for growing US GAAP reporting distortions makes the comparison even more flattering to EM).
Net earnings revisions momentum continued to improve for both Asian and wider EM in July, and should turn positive by Q4. There has certainly been EM multiple expansion this year but from historically low relative valuations, particularly versus the US and in line with historical experience at turning points in the earnings cycle. The outperformance of EM equities (particularly versus Europe/Japan) has been an embarrassing surprise this year to many asset allocators. In recent weeks as overextended commodity markets consolidate, stale bears have highlighted the divergence between resilient equities and the reversal in the CRB index with which they tightly correlate historically.
However, while the EM FX rally this year was led by the terms of trade recovery as commodities rallied, we’re also seeing ROE bottoming, particularly in Asia as the focus shifts from revenue growth to cost control. EM corporates are recovering from a toxic mix of overinvestment, excessive leverage and poor cost discipline in 2009-2014. The result was excess inventory, overcapacity, and ultimately output price deflation and crashing margins – in that context, it’s significant that Chinese PPI is now responding to the housing and commodity price recoveries, down just 1.7% y/y in July and set to move positive into early 2017.
Profit margins have also been under pressure since 2010 as wage growth outpaced productivity – however, wage growth is now moderating toward mid-single digits in China, or less than half peak levels. As for overinvestment, for the MSCI AXJ, capex growth is likely to be y/y negative by about 10% this year and 5% next as companies focus on cost control and margin expansion. That is broadly a positive trend, particularly in China but not in India, which has seen a sustained collapse of private sector capex since 2009 as it boomed elsewhere in the region.
There are also overlooked positive structural factors for EM as new technology bridges the chronic infrastructure deficits which have been a drag on growth. As I’ve long highlighted, ubiquitous cheap smartphones are allowing a ‘leapfrog’ effect for emerging economies – there is no longer any rationale to build out a fixed line phone or bank branch network. Instant messaging services like WhatsApp are being used by small businesses from Brazil to Bangladesh to market themselves and attract customers while mobile payments are allowing the unbanked to trade.
Alternative card payment services like Stripe are allowing small businesses anywhere to trade globally (and ‘on demand’ service exports from graphic design to software coding will become more important than container traffic over the next decade for many of these economies, from the Philippines to Argentina). Certainly, upgrading basic physical infrastructure remains crucial but the ‘economic optimization’ role of technology advances is even more valuable in countries with scarce infrastructure and high frictional logistics/transaction costs than in developed economies.
Indeed, the digitization of incremental growth will help offset the institutional weakness of many emerging economies and do more to drive inclusive growth for the economically marginalized (Alibaba in China being a prime example) that any number of well-meaning World Bank programs. That’s especially important now that the classic East Asian development model of a sustained trade surplus and captive household savings funding fixed investment is becoming redundant, given China’s unassailable manufacturing scale economies.