Earlier this summer, we discussed some of the challenges facing Emerging Market economies such as India, Brazil, and China, notably the fact that the “low hanging fruit” had been picked in these countries economically and that the next stage of economic development would require a commitment to addressing infrastructure deficiencies, worker education and productivity, political accountability, and other issues such as the costs associated with environmental degradation. Of course, in recent weeks, the rout in emerging market currencies, not to mention risk markets, has captured the attention of the financial world. While the Indian rupee, for instance, has shown a little backbone today, since early May the rupee has fallen approximately 20% in value versus the US dollar. Going back to the summer of 2011, the fall totals approximately 45%. The Brazilian real has shown a similar dynamic. Remember, it wasn’t so long ago that Brazilian government officials were complaining about a potential global currency war as the real appreciated too much for comfort. Now foreign capital is exiting emerging markets rapidly. Perhaps we can blame the QE/tapering cycle in the US. Whatever the reason, emerging market officials face an unpalatable series of choices right now, such as raising interest rates to defend currencies just at the moment economic growth is sputtering.
Warren Buffett famously said, “You never know who’s swimming naked until the tide goes out.” It’s becoming apparent that many economic issues in the emerging markets over the past decade were papered over by the fact that foreign money was pouring into the economies and markets and the fact that commodity prices were rising. The Warren Buffett quote is apt in this situation.
On that note, we were struck by an op-ed piece in yesterday’s Financial Times by Peterson Institute for International Economics fellow Anders Aslund that succinctly addressed the issue. Titled, “Now the Brics Party Is Over, They Must Wind Down the State’s Role,” it’s a great short read to give a sense of how the governments in many of these countries squandered the economic gifts given to them over the past decade to prepare their economies to achieve higher levels of economic prosperity in future decades. A few quotes from the article stand out:
- “During their years of plenty, the Brics did not have to make hard choices. Today, their entrenched elites seem neither inclined to nor able to do so.”
- “Governance is mediocre at best, reflecting substantial corruption and poor business environments…The World Bank compiles its ease of doing business index for 185 countries. The Brics do even worse by this measure, with China ranking 91, Russia 112, Brazil 130, and India 132.”
- “Their ability to get going again rests on their ability to carry through reforms in grim times for which they lacked courage in a boom.”
We couldn’t agree more with these sentiments, and encourage you to read the article, the link to which is provided at the bottom of this blog post.***
Shifting gears to the investing angle to all of this, is all hope lost as far as emerging market equities are concerned? We’ve spoken on numerous occasions about not confusing the negative or positive “stories” surrounding various political and economic dynamics around the world with future equity market performance. As we’ve mentioned in many cases, there’s oftentimes a “darkest before the dawn” aspect to equity market investing; the bad stories are often already captured in equity market prices, and in turn represented by low valuations. Certainly, the hardest thing to do, however, is make a commitment to equity market investment opportunities trading at very low valuations while a bunch of bad news circles a particular stock, a particular sector, or a country/region. This is no different than the dilemma many investors face resisting the temptation to chase an expensive stock or other investment because the surrounding story is so deliciously wonderful.
The issues facing many emerging market economies are daunting for sure, as captured well in the above linked essay. Yet, the MSCI Emerging Markets Index is now plumbing long-term valuation levels not seen since the dark days of the global financial crisis. Currently, the index is trading at 14x on a 10-year normalized basis, the lowest since March 2009. Emerging market equities have gone nowhere for 4 years. As we’ve mentioned before, even the EAFE developed markets ex US index, which holds a healthy dose of European exposure, has trounced the emerging markets index. Who saw that coming?
As such, we think this is a good time to start keeping an eye on this segment of the market, even if the news flow may get worse from here. From a technical analysis standpoint, we think there is a decent probability for more downside in prices; it may not be time to catch a falling knife just yet. And, fundamentally, there’s nothing out there that says an index trading at 14x can’t go to 8x. Investors have seen that story many, many times. But, again, don’t let the negative news flow keep emerging market equities out of the investing consciousness. At some point, emerging market equities will find price stabilization and provide outsized returns, in our opinion, relative to developed markets. Even now, at 14x versus 18x in the EAFE and 22x in the S&P 500, a strong case can already be made that 10-year future annualized returns could be much stronger here than in developed market equities for those willing to patiently endure some potential bumps in the road.
We’ll see how it all shakes out, but it will be interesting to look back on this moment in several years to see if, once again, valuation trumps conventional wisdom.
