“Everything about investing in emerging markets right now is relatively predictable,” said Gary Greenberg, Hermes head of emerging markets.
“Trump is the only unknown. We know that Chinese GDP is slowing to around 5.5%. We know that Russia will continue to meddle in neighbouring countries and negotiate over energy tariffs. We know that Brazil is emerging from recession. We know that South Africa will muddle along – despite a difficult economic backdrop. We know that Mexico will have an election next year. What we can’t predict is what President Trump will do – or even say.”
Speaking at a press briefing this morning, Greenberg, who runs the five-star Hermes Global Emerging Markets fund, said that policy risk from the US posed the greatest risk to emerging market investor returns right now.
“It won’t be the Fed raising rates that causes a problem,” he expanded. “Most emerging markets could take a rate rise of up to 1.25 percentage points, apart from perhaps Turkey and South Africa. The concern is Trump’s rhetoric turns to action over Korea. If China was to oppose the US in its approach you could see a trade war ensue.
“The US market is also at risk – and if something went wrong in the US, emerging markets are not immune. In a risk off environment both would sell off. We’re invested in companies with less external vulnerability in the portfolio but it is a risk.”
Taking a Contrarian View on China
Trump risk aside, Greenberg is positive on the outlook for emerging markets, especially China, which is in stark contrast to many of his peers.
“We are overweight in China compared to the benchmark. We recently bought a Chinese bank ICBC. Many of my fellow investors are concerned about non-performing loans in the Chinese banking system and conclude that a collapse is imminent,” he said. “But we think this is only a problem in small banks. For big banks that segment is under control.”
But it is tech stocks that Greenberg is really excited about, saying that China will soon rule the world in technological innovation – and is close to outstripping the UK in terms of IT’s contribution to GDP.
Since 2004, tech has gone from a 0% contribution to Chinese economic growth to more than 15%. In the UK, tech makes up 17% of GDP.
“China has pledged to lead the world economically and politically by 2050. I do not know whether we will all be living under Chinese rule by then, but they certainly will be at the front when it comes to IT,” he admitted.
In certain sectors China is already at the forefront of innovation; their online payment system is more advanced than that in the West, ditto video surveillance technology and social media add-ons.
E-commerce is a big deal – it is not just about Tencent (00700) and Alibaba (BABA) either.
“There is a tremendous addressable market in e-commerce,” said Greenberg. “Companies have good free cashflow and are investing in innovation.”
Innovation played a considerable part of stock market returns in the developed world in the 30 years to 2015. In 1975, intangible assets – innovative, knowledge based companies – made up just 17% of the S&P 500 by market cap. Tangible assets – capital expenditure heavy, industrial stocks – made up 83% of the market. By 2015, this split had become 84%/16% in intangible assets' favour; with companies such as Facebook (FB), Amazon (AMZN), Microsoft (MSFT) leading the charge.
The same shift is happening across emerging markets, with China moving away from its old economy; the factory of the West, to its new economy of technology, artificial intelligence and e-commerce. These will be the new driving forces of stock market returns for investors.
How Long Can the Emerging Market Rally Last?
Greenberg recognises that the year and a half has seen a good run for emerging market returns, and classifies the cycle as at its mid-point.
Currently, valuations on a price-to-book measure are at 1.6% for emerging markets – 2.4% for developed markets. Greenberg expects the rally to last at least another year, and for price to book to reach 2%, but warns that when emerging market valuations begin to look as good as those in the developed world then the good times will be over.
“Valuations are okay at the moment,” he said. “I expect emerging markets to outperform developed markets over the next year. Profit margins are rising – partly because of commodity prices but also because of technology. But I have some concerns about China’s debt levels and the US. The threat of nuclear war is an obvious issue.”
