Build a global portfolio: where to look for growth and value now
The Covid-19 crisis and ongoing jitters over world trade have left emerging markets unusually cheap – yet their long-term growth prospects remain compelling. It’s time to buy, says Matthew Partridge
We all like to think of ourselves as cosmopolitan. But while we may watch the latest Hollywood films, buy electronic goods manufactured in China and eat Thai food, when it comes to our money, we’re far less adventurous. British investors have long exhibited a strong “home bias”, favouring domestic assets over foreign ones. A 2018 survey, for instance, found that 75% of respondents intended to invest most of their money in their home market, even though UK equities accounted for just 6% of the global market.
Some geographical diversification, however, is important in an equity portfolio. There are some compelling opportunities abroad, especially in the developing world’s equity markets, known as emerging markets. They now offer investors an attractive blend of rapid economic growth, auspicious long-term prospects and cheap valuations.
A big discount to developed markets
Emerging markets look attractively priced, both in absolute and relative terms. As far as the latter is concerned, they are “already discounting the negative impact of the [pandemic] to a much greater extent than in developed markets”, according to Kunjal Gala, Lead GEM Fund Manager at Federated Hermes. Emerging markets now have an average price/earnings (p/e) ratio around 30% lower than that of developed markets, compared with a long-term average gap of 20%. Similarly, the gulf between the average price-to-book (p/b) ratios of emerging and developed markets has widened to 36% from its long-term average of 17%.
Gala says the gap between valuations in developed and emerging markets is the widest it has been since early 2009. This disparity is “remarkable” given that companies in emerging markets are producing returns on equity (a key gauge of profitability) at least as good as those in developed markets.
Gala’s conclusions are mirrored by research from StarCapital AG, which also finds a large valuation gap between the two parts of the global economy. It finds that while emerging markets have an average p/b of 1.6, the figure for developed markets is 2.2. MoneyWeek’s favourite valuation metric, the cyclically adjusted p/e (Cape), takes the average of the last ten years of earnings rather than just the last four quarters in order to smooth out the impact of the economic cycle. While emerging markets have an average Cape of 15.5, developed markets have one of 23.6 – a difference of over 50%.
The pandemic will clearly have a “negative impact” on emerging markets “in the short to medium term”, says Divya Mathur, emerging markets portfolio manager at Martin Currie. However, Covid-19 seems unlikely to be as bad as the steep valuation discounts to rich countries’ equities imply; the position of emerging markets’ economies relative to those of developed countries isn’t as bad as you might think.
Trade fears are overblown
Emerging markets are typically more dependent on global trade than their developed counterparts, so concern that the multi-decade expansion in global trade will be brought to a halt are depressing valuations. Part of this is due to signs that Covid-19 is already “starting to lead to an increased focus by multinationals on simplifying supply chains”, which can only “reinforce the recent trend to onshoring (moving production back to developed markets)”, says Rupert Thompson, chief investment officer of Kingswood. Thompson also notes that there has also been a rise in “protectionist pressures” over trade, especially between the US and China, which will have “spillover effects on the rest of emerging markets”.
However, others are more sanguine. Most of the negative impact of the pandemic on global trade “has now passed”, says Patrick Zweifel, chief economist at Pictet Asset Management. He notes that trade levels have fallen much less in emerging markets than in the rest of the world, helped by a rebound in exports during the summer. Zweifel is also sceptical about claims that the pandemic will lead companies to move production back to developed markets in order to consolidate their supply chains. “Whatever they may say,” large firms are unlikely to leave emerging markets to any significant degree as they “depend on the low labour costs in less developed countries to stay competitive”.
US money printing bodes well
Zweifel also notes that even if US trade policy has rattled emerging markets in recent years, this is balanced by US monetary policy. The Fed’s aggressive money printing has weakened the dollar, which, since commodities are priced in dollars, is “generally supportive for commodity prices and those countries which export them, which tend to be emerging markets”. Goldman Sachs’ Commodity Index (GSCI) has already increased by around 50% since March.
A broader point is that a strong dollar, bolstered by the prospect of US interest-rate rises, makes American assets more attractive by increasing their anticipated yield. This tends to draw money away from traditionally risky assets, such as emerging markets.The opposite scenario – US money printing and no prospect of a rate rise anytime soon – promotes investment in emerging markets.
Solid medium-term foundations
Not only are investors overestimating the impact of coronavirus and trade wars on emerging markets, but there is also strong evidence that emerging economies are continuing to catch up with developed countries, says Gala. The latest predictions by the International Monetary Fund in its June World Economic Outlook forecast suggests that emerging markets will not only contract by just 3% this year compared with an average of 8% for the most advanced economies, but will also outpace them in 2021, growing by 5.8%, compared with 4.9%.
This gap between emerging and developed market growth is likely to continue beyond the pandemic and into the medium term, says Gala. Although the technology boom may have begun in the United States, it is now spreading to lower-income countries, led by large investments in 5G technology to enable much faster communications. Emerging markets are also undergoing major social changes, with a new middle class emerging as countries gradually become richer. Improved infrastructure is also driving growth.
One sign that emerging markets are becoming an important force in their own right is their trade policy. Rather than just waiting for richer countries to remove trade barriers, many states “have been working hard to liberalise trade between [each other] in recent years”, says Mathur – witnesses regional co-operation such as that of the Association of South East Asian Nations (ASEAN), as well as “major multi-country initiatives, such as China’s Belt and Road infrastructure programme”. Such measures will prove to be “significant drivers of growth”, even if the rest of the world becomes “more economically insular”.
Mathur also notes that emerging market economies have “undergone significant structural changes over recent years”, which have helped them become more resilient. Public health systems have improved, for instance, allowing Asian countries to control the virus more quickly and with far less economic damage than in the West.
Emerging market central banks have become adept at using monetary policy to cushion the economic impact of the virus. What’s more, before the crisis most emerging market economies had relatively low levels of public debt. For example, according to the International Monetary Fund, Indonesia had debt equal to 30% of GDP, India’s debt to GDP was 43%, while even Brazil has a debt of 83%, lower than the pre-crisis levels of either the UK (86%) or US (91%). That provides scope for cushioning the impact of the virus.
Emerging Asia charges ahead
Emerging market investors tend to focus on Asia. There are good reasons for this, says Catherine Yeung, investment director at Fidelity International. Emerging Asia has done a good job of containing the virus. And its economies are developing quickly. China is even starting to develop a substantial biotechnology sector, while its labour costs have risen so much that an increasing amount of low-value work is now being outsourced to Vietnam, which is in a similar position to where China was three decades ago.
Another sign that emerging Asia is approaching economic maturity is the emergence of a domestic consumer industry. This means that it is growing far less dependent on exports, further reducing the risk of a global trade war disrupting growth. Indeed, in an inversion of the traditional model, whereby poorer countries export agricultural products to richer countries in exchange for goods and services, China is now a major consumer of US food (which makes it harder for the US to impose tariffs without upsetting farmers in the Midwestern states).
Problems containing the virus have meant that India “is going to take longer to get back to normal than the north Asian economies”, with a predicted contraction of 4% of GDP in 2020, says Gala. However, the government has introduced “structural reforms on land, labour, agriculture, power, tax and manufacturing”. Proper implementation of these reforms “has the potential to improve India’s competitiveness and sustainably increase India’s long-term growth rates”, which in turn should boost corporate profits and share prices.
The position in Latin America is more mixed, especially because many people there work in the informal economy. Not only does this make it more difficult to control the spread of the virus, as Carlos Gonzalez Lucar of RBC Wealth Management notes, but it also means that those who are unable to work are not covered by welfare and job-protection schemes, undermining confidence. Low levels of digital infrastructure in Latin American countries have also made it harder for people to shift both their consumption and their work online. The upshot has been some of the highest death tolls in the world and sharp downturns. The IMF expects the region’s economies to shrink by an average of 10% this year.
Still, even in the worst-affected Latin American economies there are positive signs that growth could bounce back, says Gala. Brazilian president Jair Bolsonaro may have been widely criticised for his “obdurate” handling of the crisis, and there is “little room” for fiscal policy to support growth, but economy minister Paulo Guedes is planning a series of privatisations, which have already led to many poorly performing state-owned firms moving to the private sector. This policy could “kick-start a major catch-up in terms of efficiency, especially in logistics, therefore transforming Brazil into a competitive producer”.
So where should investors put their money?
To read the whole of this article, subscribe to MoneyWeek magazine
Subscribers can see the whole article in the digital edition available here