EM Sell Off Brings Economic Fundamentals to Forefront
Art by James Yang
Investing in emerging markets can be an iffy enterprise—like during the Mexican peso crisis of 1994, the crumbling of the Thai baht in 1997, and the Russian default of 1998—but that is where the long-term growth lies.
Right now, the ongoing trade war between the world’s largest economic powers, the US and China, plus American tariffs slapped on elsewhere, have chilled EM bourses. Another problem: The strong dollar and higher US interest rates are pulling money out of EM stock markets. Since its January peak, the MSCI Emerging Markets Index dropped 20% a week ago, meeting the definition of a correction. (It nudged up a bit since, and now is off 19.2%.)
But for investors, the task is to position a portfolio to take advantage of promising prospects whose stocks are cheap. And it’s equally vital to be wary of bad actors that likely will get worse.
The winners all happen to have the most solid economies and the most stable governments—places like India, Indonesia, and South Korea. Vietnam, whose economy is booming, is worthy of an honorable mention.
Paradoxically, some of the strongest players are located near China, and the proximity is part of what’s troubling their stock markets for the moment (exception: India). “The winners are all in Asia,” said Howie Schwab, portfolio manager for the Driehaus Emerging Markets Growth fund.
The more problematical EMs tend to suffer from governmental and political weaknesses, such as Argentina, Turkey, and South Africa.
Here is a rundown of the top three and the bottom three among significant EMs, as we see it. We exclude nations whose investing environments are so rotten, like Venezuela with its penchant for seizing foreigners’ assets, that investing in them would be obvious folly.
THE WINNERS
India. The world’s fastest-growing major economy, which the World Bank expects will expand 7.4% this year, ranks seventh in terms of gross domestic product, at $2.8 trillion. This is one EM that seems to be largely immune to the trade clash, perhaps because of its huge domestic consumer market. Exports as a share of GDP are on the lower end for an EM: 18.9%.
The S&P BSE Sensex index has soared 11.8% this year, a better performance than any other large nation. So Indian stocks are not the bargains that other EMs’ shares are, although they’re not ruinously expensive either: The Sensex’s average price/earnings ratio is 24.
The sub-continent, with 1.3 billion people, also is the earth’s biggest democracy. And under Prime Minister Narenda Modi, it has been business-friendly. Witness his new bankruptcy code, making recovering debts owed easier for creditors; revamping banking regulation to bolster lenders’ balance sheets; and allowing more foreign capital to enter the country.
Inflation, at 4.3%, is troublesome. An undervalued rupee at least is a boon to exports, though.
Indonesia. GDP growth here is moving up smartly, with 5.2% forecasted for this year. Its economy is the world’s 16th-largest at $1.1 trillion, and the biggest in Southeast Asia. Household spending is up 5% year over year. Economic reforms under President Joko Widodo—like weeding out layers of regulation, opening government-owned industry to private ownership, and better tax collection—should keep up the momentum, the World Bank says.
But Indonesia has seen its currency, the rupiah, suffer from capital outflows seeking better returns elsewhere. The Jakarta Composite is down 6.7% in 2018 (P/E: 15, better than the S&P 500’s 18). The government budget deficit and the current account deficit are on the high side, but much of that is due to its ambitious infrastructure spending effort, which should pay off long-term. Exports make up 20% of GDP. Some of its raw material exports are down in price, such as rubber and palm oil, while a resurgence in oil pricing is offsetting that. Crude is its largest export. The bottom line is that its weaknesses are temporary.
South Korea. Relations with neighboring North Korea have improved markedly this year amid the sometimes-belligerent North’s improved dealings with Washington over Pyongyang’s nuclear arsenal (a truce that admittedly could sour rapidly).
Yet South Korea, an exporting dynamo (43% of the economy) whose GDP should increase 3.1% in 2018, is on track to keep the good times rolling. The 11th-largest economy has a $2.1 trillion GDP. Over the past two decades, auto production has climbed in value almost five times, computer chips have tripled, and liquid crystal displays (a.k.a., flat-screens) 80 times.
And the chaebol, which are South Korea’s mighty conglomerates, have indicated a desire to be more shareholder friendly, noted Arjun Jayaraman, who heads an EM fund at Causeway Capital Management.
The fallout from the US-China clash hasn’t done the South’s stock market any favors lately. The Kospi Composite has slid 6% this year. Nevertheless, Korean stocks are cheap. The Kospi’s P/E is just 11. “Samsung’s P/E is 6.5 times 2018 earnings, lower than Apple’s,” Jayaraman added; Apple’s multiple is 20.
THE LOSERS
Argentina. The land of the perpetual financial crisis, Argentina between 1980 and 2001 has suffered six of them. As a result, the South American nation was shut out of world financial markets for years. Things seemed to turn around with the 2015 election of President Mauricio Macri, who soothed international investors by ending restrictions on capital flows in and out of the country and by finally settling with creditors owed money from the 2001 debacle.
Once again, the 21st-largest economy (GDP: $626 billion) loaded up on foreign-provided debt. Alas, the nation showed scant progress in lowering its government deficits and refused to raise interest rates despite mounting inflation. Making matters worse was a drought that trashed its vital corn and soy production. Despite a new $50 billion International Monetary Fund line of credit and a central bank reversal—it jacked up rates by 60% recently—confidence remains low. The Argentine peso continues to plunge. Its stock market is ahead a mere 0.28% this year.
Turkey. Not too long ago, this nation (its economy is ranked No. 18, at $1 trillion) was a bright spot, with a 7.4% annual GDP increase in 2018’s first quarter. Trouble is, enormous borrowing from the West, denominated in increasingly higher dollars, has cost Turkey dearly. The strongman leader, Recep Tayyip Erdogan, has made matters worse by picking a fight with the US over the arrest of an American pastor. President Donald Trump has hit Turkish steel and aluminum with weighty tariffs.
The lira has plunged 40% this year and the stock market 18%. Amid accelerating inflation, the central bank has defied Erdogan’s wishes and last week raised interest rates. Most experts expect Turkey will tumble into recession soon.
South Africa. One of the world’s shakiest economies, South Africa has been cursed with rampant inequality. The unemployment rate is 27%. In a bid to redress that, the government embarked on large-scale social spending, which has ballooned the deficit to the point that external debt is half of GDP, compared to 37% five years ago. South Africa is now in a recession, with its economy shrinking for two quarters in a row (negative 2.6% in the first quarter and minus 0.7% in the second).
The economy (ranked 37th, at $371 billion, the second-largest in Africa after Nigeria’s) is 30% exports, and its chief products to ship aboard, metals, are mainly down on world markets. The rand is off nearly 20% this year. The stock market has dipped 6% this year.
A major contributor was the rule of President Jacob Zuma, beset by rampant corruption, which has done little for business confidence. After his own African National Congress party forced out Zuma in February, ANC successor Cyril Ramaphosa has his hands full putting the house in order.
The good news is that “we’re seeing little contagion,” where economic weakness spreads across the EM landscape, said Ron Joelson, chief investment officer of Northwestern Mutual. That’s a good thing. The world doesn’t need any more problem EMs.