Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here Scott Berg, portfolio manager of the T. Rowe Price Global Growth Equity Fund discusses emerging markets.
Whether looking at absolute or relative returns, economic growth figures or delivered earnings growth, many emerging market index statistics over the past few years have made for painful viewing.
However, it is important to note that the nature of index construction has played a big role in how disappointing the picture has been for emerging markets. This is because much of the pain felt by investors has centred on the largest markets, most notably the BRICs (Brazil, Russia, India, China), reversing the powerful trend of steady and consistent outperformance that followed the Asian and Russian financial crises in 1997- 98, but largely ended as the global economy collapsed in 2008.
So why have non-BRIC emerging market stocks fared better? We believe this is largely because more non-BRIC nations have delivered to a greater degree on the promise of the emerging market thesis put forth a decade ago – that economic growth, fuelled by domestic factors such as favourable demographics and consumption growth, would lead to superior corporate profitability, which would drive superior returns for investors.
While the path has not always been smooth, non-BRIC countries such as the Philippines, Peru, Indonesia, Egypt and Thailand have delivered on this promise over the past decade. In contrast, where this thesis has failed, as is the case with Russia, there has been commensurate underperformance versus other emerging market countries and versus developed market peers.
Taking the current fundamentals of Brazil and Russia, economic growth has collapsed with economic contraction possible in both countries in 2015. Brazil remains a vibrant demographic story with excellent long-term potential, but twin deficits and a lack of political preparedness for a world defined by lower growth and commodity prices has left the economy in a very vulnerable short-term position. Russia, meanwhile, fails to meet many of the criteria that originally underpinned the BRIC thesis. Poor demographics, political isolation and an economic reliance on energy prices have all compounded genuine economic risks, both near and long term.
China still retains its advantaged economic growth backdrop and continues to be supported by growing urbanisation and industrialisation, as well as increasingly strong domestic consumption. However, the days of its economy growing by more than 10% a year are over, with GDP growth in the 6% to 7% range likely for the medium term— still high in comparison with the rest of the world, but not encouraging for those who look for acceleration to find comfort.
While painful for Russia and Brazil, the drivers of Chinese growth are being rebalanced away from the capital investment that created such a strong decade for commodity prices, with the focus now on achieving more sustainable consumption-led growth. The path will not be smooth given debt overhangs and over-capacity issues, but the opportunity by industry and stock remains a rich one.
India holds much more cause for optimism given that its economy retains so many of the positive fundamentals that create a fertile growth environment. In addition to its advantaged growth position, structural reforms taken by Prime Minster Narendra Modi are encouraging. In just eighteen months, India has moved from being at the centre of the ‘fragile five’ storm, to be held up as a reformist, growing economy with falling inflation and a minimal current account deficit.
In our view, the BRIC markets have fundamentally changed over the past decade with the positive change thesis playing out very unevenly. Therefore, there is a need for adjustment as we move forward. We would stress that there is a very strong case for selectivity within investing, and this belief does not infer a strong case for a passive, benchmark-oriented approach. The end of the commodity super-cycle and the evolution taking place within many emerging market economies is real and will have strong implications, both negative and positive. Investors will need to think in a more granular way in order to capture these trends.
We believe we will see an uneven world going forward, with less correlation and more dispersion of returns across countries, sectors and stocks. While it is a more complex environment, this should provide more opportunities for thoughtful investors to take advantage of valuation anomalies and temporary crises of confidence that is part of investing.
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