Silver linings for stormy emerging markets

A hike in interest rates by the U.S. Federal Reserve and a strengthening U.S. economy are historically bad news for emerging markets.

So earlier this month, it seemed like a self-fulfilling prophecy when emerging market debt sold off as investors sought the safety of higher rates in the United States.

Yet some following this sector argue this time is different from five years ago when the United States announced it would begin tightening monetary policy, causing the so-called “taper tantrum“ that sent emerging markets roiling. Among those bullish on emerging markets are three portfolio managers of emerging-market equity mutual funds, who offer five reasons why history is unlikely to repeat itself.

This time, the debt is different

In the past, emerging market economies relied much more on the inflows of foreign currency to support their economies. Many raised capital in foreign denominations, particularly in U.S. dollars. As a result, when the greenback rose relative to their domestic currencies, those debts became harder to pay back, says Louis Lau, investment director and emerging market specialist for Brandes Investment Partners.

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“Today the situation is different because a lot of the debt raised is in local currencies and with longer maturities,” says the San Diego-based portfolio manager. “So in terms of capital flight that will take place, it’s no longer as scary as it was.”

That doesn’t mean some developing nations won’t struggle. Both Turkey, struggling to reduce its large current-account deficit, and Argentina, which has hiked interest rates to 40 per cent, will be challenged to sustain growth. “But the global interest-rate cycle is no longer synchronized as it once was.”

It’s all about the economic cycle

Emerging markets have just come out of a recent downturn that began in 2013, and for this reason, these economies are arguably in a better position for medium-term growth than developed markets, says Phil Langham, a London-based senior portfolio manager and head of the emerging-market equities team for RBC Global Asset Management.

“Developed markets have been in an upturn for earnings and GDP growth for several years now, whereas emerging markets have just started to see an upturn in 2016.” Moreover, emerging markets are trading at a discount to developed markets. Mr. Langham adds that emerging markets are only now entering the mid-cycle of a bull market. “So, from a medium-term view, these markets are more likely to be up than down because they’re still in a recovery where we expect to see improvements in profitability and growth.”

No pain, no gain

Investing in emerging markets inevitably involves short-term pains for long-term gains. That’s why anyone investing in emerging markets should plan to buy and hold these investments for several years, if not decades, says Peter Lampert, portfolio manager for emerging-market equity at Mawer Investment Management.

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Rising U.S. rates “are a solid concern, and we wouldn’t try to argue that it [a downturn] won’t happen this time.” But long-term, the emerging markets’ picture is bright because their middle classes are growing rapidly and will drive expanding domestic consumption for the next 20 to 30 years.

That said, investors should seek out companies that stand to benefit from this growth like the domestic, discount airline IndiGo. “It’s just a phenomenally well-managed, and one of the lowest-cost airlines in the world, let alone India,” says Mr. Lampert, based in Calgary. Moreover, the airline has a “long runway for growth” because airline seats per capita in other emerging markets are about five to 10 times higher than India. “And developed markets are 20 to 30 times higher.”

As China goes …

Given that China’s publicly traded companies make up about 30 per cent of the MSCI Emerging Markets Index benchmark, as China goes so does the rest of the emerging markets, Mr. Lau says. And China is now much less susceptible to a rising U.S. dollar than in the past.

The main reason is the Chinese economy is more driven by its fast-growing domestic consumer market than ever before. In turn, it has also eased its reliance on commodity-based industries such as steel production. “China realized the last time it can’t build bridges to nowhere and churn out steel forever, so it had to change its quality of GDP growth,” Mr. Lau says.

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Other emerging markets are benefiting too, and not just from serving China’s expanding consumer demand. Their commodity industries are seeing better near-term prospects, including steel producers in South Korea and Mexico, he notes.

Additionally, China is cleaning up its financial sector, including tighter regulation for its growing wealth products segment. Mr. Lau says many of these investments provided guaranteed returns and principal for domestic savers. Held on the banks’ balance sheets, they “posed a systemic risk.” But new regulations are forcing these products to follow a net-asset-value model similar to mutual fund products offered in the United States and Canada in which the value of and return on these investments vary according to economic and market conditions. “The move will shrink some of the fees the banks have been earning, but it will make the system safer overall,” Mr. Lau says.

No matter the locale, good management matters

Undoubtedly plenty of companies listed on emerging-nation stock markets remain “uninvestable,” says Mr. Langham. They’re poorly managed and at best their profitability — if they are at all — is dubious. But a number of good companies can be found, providing investors with significant value for their dollar, especially amid the recent upheaval. Additionally many of these well-managed firms are profitable regardless of the economic conditions in their domestic markets. In fact, many fare even better because they are often positioned to profit from the inadequacies of their poorly managed peers.

Mr. Lampert points to two emerging-market banks as examples: India’s HDFC Bank and Brazil’s Itau Unibanco. “People are concerned about the upcoming storm, but these two companies didn’t just survive the past one; they thrived,” he says. “They came out in a stronger position than they were before.”