Wednesday, 28 December 2016

Back to BRIC (Part Two)

Following last week’s article regarding the BRIC economies, I received emails from clients curious to know just how strongly I believed in BRIC and more specifically what statistics I could show to suggest that recent improved performance of emerging market countries would continue.  As a result I decided to follow on from last week’s article and go into a little more detail regarding some of the key economic factors behind the scenes.
The drivers of emerging markets underperformance over the past several years, such as uncertainty over US Federal Reserve interest rate policy, US dollar appreciation, global growth prospects, and declining commodity prices, appear to be dissipating.  Even with the strong performance of 2016, I believe that emerging markets still have room to run. Compared to developed markets, emerging markets equities have similar profitability levels but are much less expensive, and I believe it is an opportune time to consider an allocation to emerging markets stocks for the medium term. (Note: allocation and medium-term are key)
Here are the main reasons why:

-       Improving Current Accounts
After peaking in late 2007, current account balances in the emerging markets deteriorated as global growth and trade slowed. Since 2013, however, these current account balances have improved. In 2016, emerging markets export growth has increased due to higher oil prices and some stability in the US dollar.
-       Superior Debt-to-GDP Ratio
While US dollar–denominated debt has increased in both emerging and developed markets, emerging markets debt to GDP is still less than half that of the US and lower than both the UK and eurozone. Importantly, China has driven the majority of the debt increase in emerging markets. When China is excluded, emerging markets have relatively stable debt to GDP.  Investor fears about a Chinese credit crisis may be unwarranted, and although China’s debt to GDP remains high it is still lower than that of those in the developed markets, including the United States and Europe. In addition, China’s shadow banking system is less than 50 per cent of GDP, compared to the United States and the euro zone, where shadow banking exceeds 150 per cent of GDP. The growth of non-performing loans (NPLs) has accelerated in recent years, but considerable work has been done to manage NPL formation, including provisioning, restructuring, and writing off bad loans. We are encouraged that most of China’s debt is issued in its local currency.
-       Attractive Yields
After the financial crisis many emerging markets central banks tightened policy, while central banks in the developed markets cut rates and implemented bond-purchase programs, pulling yields toward the zero-bound, or even into negative territory. As investors continue to hunt for higher real yields globally, they have been migrating back to emerging markets assets across fixed income, currencies, and high-dividend equities.

-       Lower Inflation, Higher Growth
Over the past few years, several emerging markets have been plagued by inflation, which has hindered their economic growth. Recently, however, inflation has slowed across emerging markets, allowing for a more accommodative central bank policy. While emerging markets currency appreciation against the US dollar has helped reduce inflation, we believe the key drivers have been weak capacity utilisation, growth, and pricing power.

In conclusion, after an extended slump, emerging markets have rebounded strongly in 2016. However, relative valuations have not changed significantly as emerging markets equities remain inexpensive compared to other global equities. For 2017 (and beyond) I see emerging markets as an exciting opportunity as part of a well-balanced portfolio that will provide access to some relatively cheap company equities, many of whom continue to show string and resilient profitability.

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