Are Emerging Markets Just Getting Started?

Talking Points

  • Despite recent strength, emerging markets (EM) appear to have room to run.
  • Stable currencies should boost growth.
  • EM economies are diverse and no longer driven by commodities.
  • In our opinion, valuations continue to create opportunities in the near- and long-term.

Enduring Markets

Rate hikes in the U.S., pedestrian growth of developed economies, and a fragile energy market have led to doubts about the staying power of the ongoing surge by EM equities. We believe this view overlooks stabilizing local currencies, differentiation among national economies, the long-term potential of developing regions, and continued attractive valuations.
 
A look at the recent past may explain why some are hesitant to embrace the recent strong returns among EM names.
 
Much of 2015’s poor performance was tied to weakening local currencies. Among the hardest hit were energy producing countries that faced a one-two punch of lower crude prices and higher debt servicing costs. Brazil highlights the challenge. During 2015, the Real was off more than 45% versus the U.S. dollar. At the same time, oil, the country’s third largest export, remained well below historic averages. The combination was painful for investors with the major Brazilian market down 13.3% in local terms and nearly 42% on a dollar-denominated basis. The country has made strides in turning the corner even as crude prices remain volatile.
 
Fast forward to today. Brazil’s steady currency has been a boon for investors. The Real has firmed with the reduction in inflation allowing the central bank to reduce short term interest rates. Recent political setbacks aside, the benign situation has led to greater interest in the region and the Bovespa—Brazil’s primary stock exchange—is up almost 18% in local denomination and 22% in U.S. dollar returns through the first eight months of the year. We believe other emerging countries will continue to benefit from a similar dynamic.
 
Signs of Firming Currency

Heartland Advisors International Value Investing Portfolio Manager Perspective Currency Chart

Source: SMBC Nikko Securities, Inc., 1/1/2015 to 9/13/17
Emerging Currency Index is proprietary to SMBC Nikko and is compiled from a simple average of standardized values for major emerging currency (start-2010=100).

Stabilization is a growing theme in developing markets and has shown signs of resiliency. As the chart shows, EM currencies weakened significantly in 2015 on fears of U.S. rate tightening. However, when expectations of higher rates ticked up in the first half of 2016, the reaction was muted. Stronger local currencies can keep inflation in check and provide more flexibility for policy makers to spur growth domestically.

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Author

Heartland Advisors Value Investing Portfolio Manager Robert Sharpe

Robert C. Sharpe

Sharpe is Vice President and Portfolio Manager of the International Value Fund. He has 34 years of industry experience, 4 at Heartland.

Beyond the BRICs

Skeptics of current EM strength note that mature markets are laboring under a low- or no-growth environment. As a result, commodity demand could remain sluggish and upside potential for exporters may be limited. We believe this view understates the strength of local consumers in budding regions.  
 
Exporters Brazil, Russia, India, and China (BRIC) remain dominant among emerging economies, but opportunities are widespread and less driven by commodity producers. For example, holding Grupo Nutresa, CB (NUTRESA CB), a food processing conglomerate in Columbia, has been a significant contributor as it has been able to maintain margins in a highly competitive space. The company is indicative of our EM exposure, which is diversified among sectors and lacks direct Energy exposure. 
 
As inflation subsides, so too has its eroding effects on currency. The greater spending power has prompted consumers from Thailand to Indonesia to open their wallets, as the chart illustrates. While the uptick in spending may not make a meaningful impact to economic data, the increased sales can be significant at the company level and should benefit active stock pickers.
 
Weaker Inflation and an uptick in Sales?

Heartland Advisors International Value Investing Portfolio Manager Perspective Thailand and Indonesia Charts

Source: SMBC Nikko Securities America, Inc., 1/15/2000 to 6/15/2017
Inflation rate is represented by Thailand Consumer Price Index
Source: SMBC Nikko Securities America, Inc., Retail
Sales: 1/15/2004 to 6/15/2017; Inflation Rate:
1/15/2000 to 6/15/2017
Inflation rate is represented by Indonesia Consumer Price Index

 

Heartland Advisors International Value Investing Portfolio Manager Perspective Thailand ChartSource: SMBC Nikko Securities America, Inc., 1/15/2000 to 6/15/2016
Inflation rate is represented by Thailand Consumer Price Index

Heartland Advisors International Value Investing Portfolio Manager Perspective Indonesia ChartSource: SMBC Nikko Securities America, Inc., Retails Sales: 1/15/2004 to 6/15/2016; Inflation Rate: 1/15/2000 to 6/15/2016
Inflation rate is represented by Indonesia Consumer Price Index

A Long-Term Case

Recent strength aside, we have long been constructive on emerging markets due to a combination of population growth and improved standards of living. In developing economies, the middle class is growing rapidly. 

More young adults are moving to cities, entering the industrial work force, earning higher wages—and enjoying access to an array of consumer goods and services. The world’s middle class population numbered 1.8 billion in 2009.* By 2030, it’s estimated to rise to almost 4.9 billion—a 160% increase in just 21 years.* As this development progresses, the number of middle class consumers will expand dramatically, increasing their share of total global spending. 

The expanded purchasing power of more people earning higher wages can drive growth. This trend is benefiting companies in a number of industries where valuations are reasonable, including automotive, aerospace, and rail stocks. Auto manufacturers and parts suppliers stand to gain as more consumers can afford to purchase cars. In China size and population are creating opportunities for airplane manufacturers, particularly those making aircraft that are suited to the country’s domestic travel market. Similarly, less affluent residents are contributing to stronger rail passenger traffic, and rising volumes of goods being produced and shipped are increasing freight traffic levels.

Selling at a Discount

While we believe the recovery in emerging markets has staying power, for prudent investors, the group only represents an opportunity if stocks are trading at compelling multiples. As the chart shows, valuations are attractive even when adjusted for cyclicality of the business environment.

Emerging Markets: Setting up for a Strong Run?

Source: Copyright 2017, Research Affiliates. Reproduced and republished with permission.  All Rights Reserved, January 1990 to June 2017
**The emerging market Cyclically-Adjusted Price/Earnings (CAPE) ratio is based on the MSCI Emerging Markets Index (prices and earnings in U.S. dollars), which provides earnings data starting in 1995.  Prior to 1995, the MSCI Index data were augmented by data from Global Financial Data (GFD), which reports both total return and price index data for emerging markets. Using this data it is possible to infer the dividend yield for each period that is used, along with the average payout ratio, from the current MSCI data to calculate the earnings per share and CAPE prior to 2005. Details on creating a historical emerging markets index can be found in the Credit Suisse Global Investment Returns Yearbook, 2014.
Economic predictions are based on estimates and are subject to change.
Past performance does not guarantee future results.

Heartland Advisors International Value Investing Portfolio Manager Perspective CAPE Chart

At less than 14x on a cyclically adjusted Price/Earnings ratio, the group is trading at levels seen in the late 1990s and during the tech crisis of the early 2000s. In the past, when the group has traded at these levels subsequent 10-year returns have been in the double digits.

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*Kharas, H. (2010), "The Emerging Middle Class in Developing Countries," OECD Development Centre Working Papers, No. 285, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/5kmmp8lncrns-en

Past performance does not guarantee future results.

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As of 8/31/2017, Grupo Nutresa, CB represented 1.81% of the International Value Fund’s net assets. Portfolio holdings are subject to change. Current and future holdings are subject to risk.

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