Good year for emerging markets?

Schroders Plc Client Portfolio Manager Edward Evans

STARBIZWEEK met up with Edward Evans (pic), who is part of the emerging markets (EM) equity team with Schroders Plc, at its headquarters in London recently.

Evans shares his broad view on the outlook for the EM this year, of which he reckons that 2017 would be a good year for the market after almost eight years of flat growth.

Although stocks in the EM tanked from the “Trump Tantrum” last year, there were rallies of fund inflows into the EM in the beginning of 2016.

On emerging economies, Evans says the recovery in global economies will support growth and that nations like Russia and Brazil are among his top picks, coming from a low base, and that the stock market rally would depend on oil and gas prices.

“We are constructive on the EM. The valuation seems attractive, but you need to be selective,” he says.

Below are excerpts from the interview:

The world has been undergoing slow economic growth since 2008 and the market has gone through more than eight years of a bull cycle. How do you view the market now, especially with concerns like the growth of China and Trump’s policy?

The developed market (DM) such as the United States has gone through a bull cycle, and we are currently in that theme, while the EM has actually been approximately flat. In other words, you have neither lost money nor earned it.

The MSCI EM index has been flat. Since the 2008 crisis, the index has recovered sharply, but since the end of 2009, the MSCI has been flat. Therefore, it has underperformed relative to the DM over that eight-year period. In terms of global growth, for sure it has been anaemic and boring, and we are wondering when is this ever going to change. It is interesting to note that on a year-to-date basis, global growth has actually shown a little bit more signs of synchronising pick-up in growth. However, it is not on a big scale.

This is important in the EM’s point of view because the EM, as you can imagine, is a market that benefits from increased global trading activities.

It is very good news if the global backdrop is a little bit more supportive for the EM to operate. Now, the EMs are doing far more trades with one another. If you go back 20 years, it was all about the EM exporting to the developed world.

For sure, we are still seeing it now, but in the last two decades, EM intra-trade has become far more important, and clearly, China is within that.

We are sort of coming into a period today where you ride off the slow global growth, but we are seeing signs of a pick-up in synchronised global activities. EM economies are looking a little bit better and a bit rosier, led by the two big economies of Russia and Brazil recovering from a very low base. Also, China, a big part of the EM growth story, has stabilised.

So, when you put these factors together, you can sum up quite a positive economic growth backdrop for the EM to perform in.

What happened to the EM last year? What are the big question marks in the market now?

The elephant in the room clearly has been the Trump presidency. What you saw last year after three consecutive years of EM underperformance against the DM and three consecutive years of net outflows where the sentiment was very poor towards the EM, is starting to change.

In 2016, you started to see the momentum coming back to the EM. The inflow started to come in. Our phones were ringing a lot, and people were looking to get into the EM.

So, at the industry level, you were seeing about US$12bil of net inflow, peaking towards the end of the summer in 2016.

Then came along the Trump election win, which basically put that momentum on hold. So, suddenly, you saw a reversal of those flows into the EM. At end-2016, industry flow was still positive, but very small.

In a short period of time, the market quickly priced in the stronger US story and potential trade protection measures.

Coming back to my point that the EM benefits from increasing global activities and global trading volume, once you start to see difficult world politics or any changes in trade policy, it could potentially be bad news for the EM.

Another point is that companies’ earnings in the EM are improving. At the end of the day, we are talking about the stock markets, and they react to long-term growth in earnings.

So, EM corporates are finally getting better in managing their businesses. They are cutting cost and managing capital better, and are investing more wisely. It is because if you rewind the scenario to 10 years ago, the EM corporates had it easy. A lot of these companies are in protected industries with heavy Government support, often related to commodity prices during the commodity super-cycle. It was easy to look good.

Clearly, since the financial crisis, the backdrop has been far more difficult. So, it is only recently that EM corporates have been improving, catching up with inefficiencies, and improving margins and growth.

The main question now on everyone’s mind is: “Has the outlook on the EM changed, or is it now the time to reconsider investments?”

What is your outlook on the emerging economies’ equity market this year?

There are two ways the Trump presidency can impact the EM: number one through trade, and number two through fiscal policy.

From the trade policy point of view, clearly in Trump’s campaign, he was very vocal about Mexico and he also said some points on China. So, everyone is very worried that there are negatives going to happen.

Ultimately, nobody quite knows the direction. We all know that President Trump likes to make noise, but in terms of actual policy implementation, it has so far been far more muted than the concerns we saw at the end of last year.

At the end of the day, the world has become very entwined globally. Globalisation has become so great that it’s not so straightforward to slap on tariffs or border controls because everything is integrated.

Quite frankly, nobody knows any trade policy change’s implications. But it seems like any moves would be far more selective and targeted than broad changes. Therefore, as an investor, the impact is going to be specific to a country or maybe to sectors or companies within that country.

On fiscal policy, as we mentioned earlier, so Trump came in and people thought “oh wow, he is going to embark on a massive infrastructure programme”, and that it would boost the US economy. That would probably mean that the Federal Reserve would need to tighten its interest rate policy quicker than currently anticipated.

This would mean tighter liquidity for the global market as a whole. Clearly, normally, an aggressive interest rate hike of the cycle would support the dollar.

Those two things – tighter global liquidity and a stronger dollar – are bad news for the EM.

Would you say that the US dollar is already at its peak?

Everyone had quite priced in the negatives last year. Since the rally in the US dollar in 2016, the currency started to stabilise and actually weakened a little bit this year. The market has sort of like calmed down. So, why is that? In part, I reckon Trump can’t just turn up and embark on an aggressive fiscal programme, there are other parties involved.

The other key point is that the US economy’s growth has been reasonably good from an employment point of view. It’s close to being full. So, when President Trump is talking about job creation, that is quite difficult to do, especially at this stage of the cycle.

Therefore, putting that together, it is unlikely that the dollar would go on any strong strengthening phase as it had done in the last 12 months.

Overall, this would remain a tail risk, not about the base case.

Valuation-wise, how is the EM like? Can you also briefly give us your comments on South-East Asia as well as Malaysia?

Our strategy is top-down country allocation. We identify the country first and then we look at the companies. Overall, valuations for the EM look reasonable. It looks attractive in the developed world.

Sadly, Malaysia is at the bottom of our model.

From the bottom-up perspective, Malaysia is structurally quite expensive. One of the reasons is because of the Government-linked investment companies that have a restriction to buy locally. So they form a big part of the market and keep stock prices high. So, it’s always quite an expensive market, which doesn’t help. Adding to that, it also impacts liquidity.

Meanwhile, in terms of the top-down perspective, Malaysia is quite a mature and developed market in the EM. Political instability is adding more headwinds. But, of course, at the end of the day, it’s about the valuations.

Indonesia and the Philippines have expensive valuations.

Nonetheless, we are neutral on China. It is a very big economy and is juggling with the Trump factor, a new economic model, a consumption-led economy, and at the same time, carrying out reform measures that had weighed on growth.

That said, China is usually misunderstood by investors. The outlook is bright and rosy for China. It has huge internal savings, current account surpluses and a controlled banking sector. I think the expectation is overcooked and valuations are becoming reasonable.