What's the difference between an emerging market and a developed market? We probably 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 with 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 government is going to do next, emerging market equities should trade on a discount to developed market equities. That's the case at the moment. Emerging market equities have had a nasty decade so far: until this year they had underperformed developed market equities every year since 2011 with last year being particularly trying (down 17% in US dollar terms).
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This year has been better: up 12% so far. But still, emerging market stockmarkets trade on an average price/earnings ratio of 12.4 times a discount of about 25% to developed market stockmarkets. 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 may notice) 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. Amid all 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 quickly feel it in their pockets) this isn't going to change. The key point is that 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. Emerging markets were always supposed to converge with developed markets in the end, of course: incomes were to equalise, institutions' governance and transparency would improve and governments would become more stable. That hasn't exactly been happening at speed. But bit by bit, it is happening.
In Latin America, 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 emerging market political stability". But the convergence and hence the argument for the disappearance of the emerging-market discount isn't just about politics (obviously). It is also about structural shifts in the economic make-up of various countries.
Thirty years ago, emerging markets were all about commodities and cyclical investments. No more. According to Ashmore Investment Management, some 50% 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 emerging markets is higher than that of the S&P 500 (23% vs 21%). The commodity component has fallen to a mere 14% less than half of what it was a decade ago.
The equity universe in emerging markets 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, ten FTSE 100 stocks account for 55% 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% 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 emerging-market stocks and developed-market stocks doesn't have to be closed by emerging-market stocks rising just as the gap in political stability isn't just being closed by emerging markets 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 emerging markets less than developed markets. 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 emerging-market side of this, you can go for a cheap ETF such as the iShares MSCI Emerging Markets or a good investment trust such as the Pacific Assets Trust (which I hold myself).
This article was first published in the Financial Times
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