Emerging markets: three to watch in 2014

Three investment specialists provide their outlook on some of the most talked-about emerging economies.

China: big changes afoot

As the world’s second largest economy, China is on the radar of most emerging market investors. Its growth-at-all-costs economic model has helped millions of citizens escape poverty over the years, but after three decades the model - with its reliance on exports and government-directed investment - is in need of a major overhaul. 

A new political leadership recently unveiled its road map (ominously called the “Decision”), and with much-needed reform on the agenda, China is a key market to watch. 

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But with Chinese economic growth not always translating into stock market returns, what needs to change for investors to benefit?  

One of the main reforms required is a shift away from an export-driven development model, which will be closely allied to stimulating domestic consumption. 

In the years ahead China won’t be able to rely upon a ready supply of cheap labour, and exports won’t be buoyed by a currency weakened by government intervention. 

To work, China’s reforms must allow millions of people to leave the countryside and start new lives in rapidly growing cities. People in cities tend to earn and spend more than those living in rural areas, and higher demand for goods and services will support new businesses, create jobs and boost tax revenues.  

Yet scant attention has been paid by officialdom to China’s consumer sector, despite domestic consumption being a powerful driver of growth in developed economies with large populations. 

We regard this as a good thing: government neglect has encouraged the growth of private enterprises and foreign entrants operating in an environment with relatively few restrictions. 

Another required reform is the banking system. According to World Bank data, China’s lenders have some of the lowest rates of non-performing loans, but these statistics are misleading; banks extend or restructure problem loans rather than acknowledge bad debt and record a loss.  

National policy dictates lending; so banks lend to inefficient state-owned companies (that may receive a government bail-out if things go wrong) and not to small firms that might have a great business. 

Banks enjoy subsidised funding in the form of low deposit rates set by regulators, which effectively guarantee their margins. The expectation that China will stand behind its banks if things turn sour underpins confidence in the financial system. 

But as the financial system heads towards a more market-oriented footing, authorities may be inclined to allow smaller banks to fail to ensure lenders take more responsibility for their own actions. 

Worryingly, a great deal of borrowing takes place in the unofficial shadow banking sector, which represents a source of rapid credit growth that is largely beyond authorities’ regulatory oversight. 

The China Academy of Social Sciences reckons the sector accounts for some 40 per cent of GDP. 

Retirees with a lack of investment alternatives buy “wealth management products” that pay too-good-to-be-true interest rates. 

This money may then be lent to companies willing to pay extortionate rates because they cannot get funding elsewhere. New products are sold to repay those that are maturing; it’s a Ponzi scheme by any other name.  

China needs to rejuvenate its public sector. The inefficient allocation of capital to state-directed investment has been responsible for problems from state-owned companies making things that people won’t buy anymore, to loans that may never be repaid. 

Productivity gains at state companies have stalled, but while the public sector remains a central feature of economic strategy, the private sector accounts for some 80 per cent of urban employment, around 90 per cent of new job creation and 65 per cent of investment, according to CLSA research. 

The public sector needs to adapt quickly, as proposed reforms will wind down preferential treatment. The brave new world envisaged by the Government will let the market set interest rates and energy prices, ending the sort of intervention that for years represented a form of subsidy in disguise. 

We would welcome a more investor-friendly investment environment. Investing in China has never been simple and could become even harder with the prospect of wrenching change. 

There are many potential pitfalls for unwary investors, including widespread opacity, poor corporate governance standards and a raw deal for minority shareholders. 

Chinese stock prices have conspicuously failed to track the nation’s growth and returns over the long term have been disappointing. Historically investors have overpaid for government-approved companies floated at inflated prices. This needs to change.  

We do not believe that news of the reforms warrants a change in the overall investment view of China, nor would we advocate making strategic investments based on the “Decision”. 

But we would argue that China is a market that should be monitored closely, to see how the reforms play out and to observe the impact on the companies in which you are considering investing. 

By Stuart James, senior investment specialist at Aberdeen Asset Management. 

India: long-term value remains 

An Asia and emerging markets sell-off has been driven by QE tapering concerns. While India is facing a crisis of confidence amid a rising current account deficit and a slumping rupee, any comparison with the situation in 1991 is premature.  

Emerging markets have been facing some general headwinds because of concerns that the US Fed is going to switch off the liquidity tap by tapering QE. 

This is driving fund flows from emerging markets back to the US. It’s affecting markets from Russia and Brazil through to India and Indonesia closer to home - there has been an indiscriminate sell-off.  

The trigger points for India are current account deficit concerns, rising oil prices, the fact they’re perceived as being behind the curve with rate rises and policy paralysis ahead of political elections. 

However, it’s important to note that we’re not in the same place as 1997/98. Policymakers have to strike a balance between growth, rate increases and inflation concerns - but Asia remains the growth centre of the world. 

Many regional economies are no longer export-dependent, and are underpinned by long-term drivers such as increased domestic consumption, rising incomes, and an expanding middle class. 

Challenges

The Rupee hit a 20-year low recently and the markets have trended downwards since mid-July, heightening concerns that the country is heading towards a crisis of confidence similar to the one in 1991. 

India is facing three key challenges: a) a large fiscal and current account deficit, b) high inflation and c) a slowdown in corporate capital spending as a result of policy inaction. Investors have been disappointed so far by the Government’s inability to deal with these problems through structural reforms, together with a global environment that has been challenging for emerging markets in general. 

However, we believe any comparison with the 1991 situation is premature, as India’s economic fundamentals are much healthier on a relative basis.  

We think investors should focus on fundamentals and take a long-term view. Valuations look attractive on almost all matrices and India is a stock picker’s market with many bottom-up investment opportunities.  

We favour companies with high quality business models and growth in overseas markets - exporters of business services, information technology, healthcare and pharmaceuticals should also benefit from currency depreciation.  

While there could be some more volatility in the short term, we believe this is a good time to invest in quality businesses from a long-term perspective. 

What to expect

Investors should expect more short-term volatility from a currency and macro perspective - however we think investors should look past these issues to long-term drivers and company fundamentals. 

Many people are asking whether India should bite the bullet and raise interest rates as Brazil and Indonesia have done in recent weeks, given that inflation is rising across all three countries. 

But if you look at India, inflation is mainly being driven by rising food and fuel prices - supply bottlenecks. Manufacturing inflation is not as steep as we’ve seen in the other two countries.  

And it’s not just about interest rate cuts. 

The Reserve Bank of India and the Government need to press ahead with structural reforms, as this could do a great deal to reverse current negative sentiment. 

There is still a lot of low-hanging fruit in India given that $150 billion of stalled projects are still in the pipeline. 

If this tap could be turned back on, then we could see a sudden reversal of investor confidence. 

By Gareth Nicholson, investment commentator at Fidelity Worldwide Investments.  

Brazil

A giant statue of Jesus, Cristo Redentor, stands over Rio De Janeiro. It is hard not to get the impression that Brazil is indeed a blessed country with its famous beaches, sunny climes and vast natural resources which, like Australia, have helped fuel a major economic boom in recent years. 

Indeed, whilst Rio and BHP are so well known to Australians, Brazil has its own mining giant - Vale - which produces even more iron ore than any of our miners and other global corporate icons including Petrobras, the world’s largest deep-water oil producer. 

What held back Brazil for so long was a mix of political and economic instability which fed a seemingly never-ending boom and bust cycle. Brazil had five different constitutions in the 20th century as one coup after another brought down successive regimes. Numerous attempts to bring stability to the wild potential of Brazil were lost. 

All this changed in the early 1990s, however, with the imposition of a serious economic plan - the so-called Plano Real (literally “Real Plan”) that helped lay the foundations for the recent boom.

A legally enforceable balanced budget was introduced, wages and prices were indexed and the Brazilian real was pegged to the US dollar. 

With inflation soon under control the real was allowed to float, and despite a temporary setback during the Asian Financial Crisis the economy soared.

Even the return of the left to the national Presidency in 2002 (when Lula Da Silva was elected) did not derail Brazil as it might have in times past. In fact Brazil found itself at the vanguard of the BRICs (Brazil, Russia, India, China) phenomenon from 2003 onward. 

At the same time as the Government finally got its macro-prudential management under control, Brazil’s middle class entered the global slipstream.

With inflation tamed and with one of the lowest levels of private debt in the world, many ordinary consumers were able to borrow for the first time. For a country with rising incomes and low debt, this was a nirvana for banks. 

Reflecting the new strength in the economy, the Brazilian real firmed from nearly four to each US dollar in October 2002 to nearly 1.5 in 2008, more than doubling its buying power.

Brazilian GDP surged from just half a trillion US dollars in the early 2000s to well over US$2 trillion now. Poverty rates plunged and the middle class surged by tens of millions. 

But then it all went wrong. Initially Brazil, like Australia, got through the Global Financial Crisis quite well. But then the ghosts of cycles past slowly crept up on the country.

Newly indebted consumers discovered the need to repay their loans was not as much fun as taking them out whilst the commodity cycle deteriorated. These events in turn laid bare imperfections in the corporate governance of some sectors. 

Finally the old enemy of inflation has made a comeback, rising to nearly 6 per cent at the end of 2013 and leading the central bank of Brazil to raise rates to 10.5 per cent this month to try and head it off. 

Harder times and the multi-million dollar cost of the World Cup have brought angry middle class Brazilians into the streets in protest. On top of all of this, Brazil is right in the middle of an election campaign that will dominate 2014. Nevertheless there are encouraging signs. 

Some banks have already dealt with their bad loans and are on the verge of upgrading earnings forecasts again.

The Brazilian sharemarket is also looking good value after a substantial sell-off, with a 2014 P/E ratio of under 10 times earnings - although the challenge as always is deciding when all the bad news has been priced in 

By James Holt, an investment specialist at Zurich Financial Services.




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