EMERGING MARKETS MAY BE POSITIONED FOR ADDITIONAL GAINS
The MSCI Emerging Markets Index generated a 37.76% gain in 2017 and substantially outperformed international developed markets as indicated by the 23.07% return of the MSCI World Index. The strong return for emerging markets followed the 11.60% advance of the MSCI Emerging Markets Index in 2016. In this paper, we identify developments that drove emerging markets performance in 2017 and discuss factors that are likely to support performance this year. We also provide updates on four of the larger emerging markets countries: Brazil, Russia, India, and China. As part of our outlook, we explain why emerging market companies with strong fundamentals that are beneficiaries of infrastructure spending, the rapid rise of the middle class, and the accelerating adoption of internet related technologies are attractive investment opportunities. Year in Review Synchronized economic growth, a weakening U.S. dollar, improving commodity prices, and attractive valuations supported emerging market equities in 2017. According to the International Monetary Fund, 184 out of 197 countries are expected to have produced economic growth in 2017, a feat that has not occurred since at least 1980. The U.S. dollar, meanwhile, declined to multiyear lows, in part due to growing pessimism regarding the potential for Washington to enact substantial policy changes. We believe that valuations were also attractive and remain appealing. Based on price-to-earnings ratios (P/E), the MSCI Emerging Markets Index started 2017 at an approximately 26% discount to the MSCI World Index. The discount increased to 27% as of the end of 2017. Economic Growth Returns to Brazil Brazil’s equity market could be bifurcated this year, with enthusiasm over the country’s resumption of economic growth potentially dampened by the upcoming presidential election. Brazil’s economy grew 1.4% year over year as of the end of the third quarter
Deborah Vélez Medenica, CFA S EN I OR V I C E PR E S I D EN T POR T FO L I O MANAG E R
Figure 1 Emerging Markets Metrics
Population (in millions)
2017 (est.) GDP Growth
2017 (est.) EPS Growth
2018 (est.) EPS Growth
12 Month Forward P/E
14.6% 15.1% 12.8
54.6% 6.8% 23.8% 14.8%
Source: Fred Alger, Bloomberg, World Bank, Datastream, and IBES. *GDP estimate for India is based on fiscal year 2018 which ends March 31, 2018. Other data for India is based on calendar year 2017.
Encouragingly, third- quarter corporate results suggest a rebound in Brazilian business with earn- ings before interest, taxes, depreciation, and amortiza- tion (EBITDA) and net income growing 19% and 21% year over year. Revenues increased at a median rate of 9%. Fourth- quarter results to date are also constructive.
of 2017 and is estimated to have grown only 1% for all of 2017 (See Figure 2). The growth would be an improvement from the 2.4% contraction in 2016. Estimates call for gross domestic product (GDP) to grow 2.5% this year. Encouragingly, third- quarter corporate results suggest a rebound in Brazilian business with earnings before interest, taxes, depreciation, and amortization (EBITDA) and net income growing 19% and 21% year over year. Revenues increased at a median rate of 9%. Fourth-quarter results to date are also constructive. The upcoming presidential election in October could dampen investor sentiment for Brazil. At the end of 2017, former President Lula da Silva and right wing Congressman Jair Bolsonaro were the leading presidential candidates. Da Silva, however, faces legal hurdles after an appeals court in January upheld his corruption conviction. The development is a continuation of corruption scandals, one of which resulted in former President Dilma Rousseff being impeached and removed from office. She was replaced by Vice President Michel Temer, who is unlikely to seek re-election. With little clarity on the upcoming election, investors are unable to assess the likelihood that potential candidates will be reformminded and if reforms initiated under Temer will be continued. Temer has assembled a pro-growth “dream team” of leaders that remains in place, and his government has enacted a fiscal spending cap that is expected to last 20 years. The cap limits spending growth to the rate of trailing inflation for all federal government branches. With more than 75% of government expenditures being mandated by law, this spending cap is extremely important. Other reforms involve making employer labor relations more flexible while permitting collective bargaining. Going forward, pension reform is sorely needed, with retirement payments now representing almost 50% of government expenditures. Pension payments are growing quickly and will soon crowd out discretionary spending; however, such reform is unlikely this year. During 2017, the Central Bank reduced the SELIC (overnight benchmark lending rate) rate 675 basis points (BPS) to 7%. The easing cycle is likely to continue into early 2018 before stabilizing. With the bulk of the easing cycle completed, government fiscal restraint will be essential. (%)
Sanctions and Potential Reforms Highlight Outlook for Russia Russian equity performance disappointed in 2017 after a strong rally at the end of 2016 that resulted from expectations that a new U.S. administration would improve relations with the country. A modest recovery in oil prices also supported the rally. U.S.-Russia relations did not improve significantly and oil price increases in 2017 were concentrated in the second half of the year. Our view on Russian markets for 2018 is uncertain as two major events early in 2018 are likely to define investor interest in the country’s equity market for the remainder of this year and possibly over the longer term. First, the “Countering America’s Adversaries through Sanctions Act” passed in August 2017 required the U.S. Treasury Department to prepare a report before February on the impact of expanding sanctions to include a ban on holding Russian equities or sovereign debt. The deadline passed without the Treasury recommending specific actions, but the department says sanctions are still possible. Investors are concerned about the impact of the potential additional sanctions. It is difficult to handicap the likely direction of the Treasury and this is further complicated by the ongoing investigation by U.S. Special Counsel Robert Mueller. Second, the Russian presidential election scheduled for March is expected to result in the re-election of Vladimir Putin. It would be his final six-year term. GDP growth rebounded from a 0.6% decline in 2016 to an estimated 1.8% gain in 2017, although the expansion has largely been driven by state investments, including infrastructure projects.With Russia’s GDP growth expected to be less than 2%, ambitious reforms are required for President Putin to cement his legacy. He is thought to need a historic mandate in the March election with a minimum 70% voter turnout and at least 70% of the vote to achieve that goal. Among various possibilities, his potential appointment of Herman Gref to head Gazpromwould be viewed favorably. Gref is currently the CEO and chairman of the largest Russian bank, Sberbank, and he previously served as minister of economics and trade. Inflation has been more subdued than anticipated, primarily due to weak consumer demand, lower food prices, and a stronger ruble (See Figure 3). An increase in inflation
GDP growth rebounded from a 0.6% decline in 2016 to an estimated 1.8% gain in 2017, although the expansion has largely been driven by state investments, including infrastructure projects.
Figure 3 Russia Consumer Price Index
Year-Over-Year Change (%)
In conjunction with the Unique Identification Number (Aadhaar), there is hope that the GST will help address system “leakage” or corruption, thereby enabling the entire amount of government subsidiaries to reach intended beneficiaries.
is likely to be limited, which could give the country’s central bank room for cutting rates. Oil remains important to the Russian economy and the government’s coffers. With oil priced at $42 a barrel at the end of 2017, Russia is expected to maintain fiscal restraint. At the same time, the Ministry of Finance has indicated it wants state-owned enterprises to increase their dividend payments from the current requirement of at least 25% of IFRS net income to 50% to further support the country’s revenues. Execution of Policy Changes Will Be Crucial for India Our constructive view on India is tempered by stretched valuations. As of the close of 2017, Indian equities had a price-to-earnings ratio of 18.7% compared to the 12.4 P/E of the overall emerging markets index. Prime Minister Narendra Modi’s government has pursued material policy changes that have laid the foundation for medium term growth while the implementation of these initiatives has caused short term weakness and “growing pains.” In late 2016, Modi’s government enacted demonetization, which was one of the most dramatic anti-corruption actions on currency to have occurred anywhere. Modi abolished Rs500 and Rs1000 rupee notes to combat illicit trade, counterfeiting, and other crimes. With the disruption from the initiative having largely passed, investors are now assessing the Goods and Services Tax (GST), which created a common tax system to increase efficiency, transparency, and productivity. In conjunction with the Unique Identification Number (Aadhaar), there is hope that the GST will help address system “leakage” or corruption, thereby enabling the entire amount of government subsidiaries to reach intended beneficiaries. More recently, the government has proposed a bailout of public sector (PSU) banks amounting to a possible $32 billion USD equivalent program that would address non- performing assets and strengthen banks’ capital to expand credit availability. In the meantime, credit demand is weak (See Figure 4). Government spending has increased only marginally in the fiscal year 2019 budget. This will need to be watched because spending has historically increased ahead of national elections. With India importing approximately 82% of its oil needs, rising petroleum prices combined with expansionary fiscal policy are a concern for investors. Modi is unlikely to risk going into the 2019 polling with a weak economy, so 2010 Source: Bloomberg. India loan growth is based on the year-over-year change in credit provided to the commercial sector. Year-Over-Year Change (%) Figure 4 India Loan Growth 0 5 10 15 20 25 30 2018 2016 2014 2012
India’s digitalization disintermediation is fast and furious, with a national identity card facilitating financial inclusion and demonetization, and the GST forcing the informal market to formalize.
government spending on existing projects should continue and the public sector bank recapitalization could accelerate credit just in time for the election cycle. Rural India continues to be a government focus. Rural areas account for the majority of the labor force (and voters) but only 15% of GDP due to inefficient production and suboptimal farm sizes. Modi has discontinued a number of agricultural subsidies and has reduced annual price hikes for crops despite two very poor monsoon seasons in 2014 and 2015. It is not known how the government will reach its target to double rural incomes by 2022. In the meantime, Modi needs a strong showing among voters next year in order to enact additional reforms. Possible actions could include increasing crop price hikes, improving the targeting of rural subsidies for items such as food, fuel, and kerosene, and making additional improvements to rural infrastructure, including electrification and sanitation. Education reform is also possible. The government has already announced “Bharatmala,” which will involve building 52,200 miles of roads with a $100 billion USD equivalent budget. India’s digitalization disintermediation is fast and furious, with a national identity card facilitating financial inclusion and demonetization, and the GST forcing the informal market to formalize. Greater data accessibility and lower prices now exist thanks to India’s newest mobile entrant, Reliance Jio, with its inexpensive 4G service. This has catalyzed competitors to upgrade their networks and lower tariffs, starting a virtuous cycle. Many investors view India as the “last” big internet market with a population over 1 billion and a millennial population burst coming by 2020. There are approximately 350 million smartphone users in the country but a much smaller percentage transacting via their mobile phones. Only a small number of mobile applications are utilized today given the limited memory space on currently available phones. That will change over time as pricing, language, and logistics are addressed. China’s Economy Continues to Be Driven by Government Policy China continues to be a policy driven market. In October, the Central Party Congress (CPC) strengthened the president of China, Xi Jinping. China continues to rebalance its economic growth model as GDP expansion is moderating. The economy grew at an estimated rate of 6.8% in 2017 and is likely to grow at a slower rate in 2018 with fixed investments slowing much faster than consumption is increasing (See Figure 5). 0 5 10 15 20 25 30 2016 2014 2012 2010
Source: Bloomberg. China fixed asset investment is based on year-over-year changes in investment in or capital expenditures on fixed assets such as buildings, plant, equipment, machinery, etc. These investments are normally made by businesses (or occasionally government).
Since the CPC meetings, a new State Council Financial Stability and Development committee was launched, new regulations on asset management products were issued, rules for online micro lending were announced, and various government entities have told provinces to stick to their property tightening measures.
While the country’s overall strategic focus is likely to remain on large policies such as One Belt One Road (OBOR) and “Made in China 2025,” policy makers are also focused on financial deleveraging, enforcing antipollution measures, and tackling the housing market. Property prices were more resilient in 2017 than expected and we believe the country’s actions to reduce real estate speculation will be an important theme this year. Property taxes continue to be introduced in various forms across different municipalities. A nationwide property tax remains possible. Since the CPC meetings, a new State Council Financial Stability and Development committee was launched, new regulations on asset management products were issued, rules for online micro lending were announced, and various government entities have told provinces to stick to their property tightening measures. China has seen accelerating divergence between its rural and urban areas, especially with the concentration of wealth along its Eastern seaboard. President Xi wants to narrow the wealth gap by 2035. Meanwhile, Xi’s anti-graft campaign is helping to consolidate power and is seen as targeting Communist Party officials who have enriched themselves at the expense of the country and the Party. Over the last five years, his campaign has resulted in the dismissal, sanction, or other forms of punishment of more than 15,600 officials across provincial, municipal, and county levels of government. Some 58,000 additional individuals have been referred for further criminal investigation. Consumption continues to be a bright spot in the Chinese economy. Offline retail sales have continued to growmore than 10% year over year with private consumption currently accounting for over 40% of GDP. It is expected to climb to 50% of GDP in the next decade. Ecommerce is also growing, having increased more than 30% year over year in every month of 2017. Chinese consumer confidence in 2017 reached its highest level since October 2014. China’s rapid growth and development have caused significant environmental damage. At the 19th Party Congress, President Xi devoted an entire section to the environment and he conducted numerous environmental inspection tours during the year. In August, the Ministry of Environmental Protection launched an aggressive “smog battle plan” and in October, targeted specific cities with an air pollution program. In response, the Hebei province, which produces approximately 25% of China’s steel output, has pledged to cut steel production by half in certain locations targeted by the program. Outlook Earnings growth and improvements in return on equity in emerging markets are being acknowledged by global investors. USD earnings growth in emerging markets in 2018 is expected to once again be stronger than in developed markets. Global economic reacceleration is clearly occurring with concerns now centered on U.S. monetary policy. A steeper than anticipated tightening of monetary policy by the U.S. Federal Reserve that could potentially lead to a massive strengthening of the U.S. dollar could be a negative for emerging markets.
Based on forward P/Es, emerging markets were valued at a 27% discount relative to developed markets at the end of 2017.
Based on forward P/Es, emerging markets were valued at a 27% discount relative to developed markets at the end of 2017 (See Figure 6). We continue to believe a 10%-12% discount is appropriate. In addition to attractive valuations, we believe investing in emerging markets companies provides opportunities to invest in the rapid growth of the middle class, increasing urbanization, and state-of-the art infrastructure. The growth of the middle class, for example, will cause emerging markets consumption to grow from $18 trillion in 2015 to an estimated $32 trillion by 2030. We believe leading emerging markets companies are well positioned to benefit from these trends.
Figure 6 Emerging Markets Valuations Are Attractive
12-Month Forward P/E Ratios
2008 Dec 2007
Source: Datastream, IBES, as of 12/31/17. Developed markets valuations are based on the MSCI World Index. Emerging markets valuations are based on the MSCI Emerging Markets Index.
Deborah Vélez Medenica, CFA Senior Vice President Portfolio Manager
Fred Alger & Company, Incorporated is the parent company of Fred Alger Management, Inc. The views expressed are the views of Fred Alger Management, Inc. as of March 2018. These views are subject to change at any time and should not be interpreted as a guarantee of the future performance of the markets, any security or any strategies managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. Risk Disclosure: Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the price of growth stocks tends to be higher in relation to their companies´ earnings and may be more sensitive to market, political and economic developments. Investing in companies of all capitalizations involves the risk that smaller issuers in which the Fund invests may have limited product lines or financial resources, or lack management depth. Special risks associated with investments in emerging country issuers include exposure to currency fluctuations, less liquidity, less developed or less efficient trading markets, lack of comprehensive company information, political instability and different auditing and legal standards. Foreign currencies are subject to risks caused by inflation, interest rates, budget deficits and low savings rates, political factors and government controls. Some of the countries where the Fund can invest may have restrictions that could limit the access to investment opportunities. The securities of issuers located in emerging markets can be more volatile and less liquid than those of issuers in more mature economies. Investing in emerging markets involves higher levels of risk, including increased currency, information, liquidity, market, political and valuation risks, and may not be suitable for all investors. The Morgan Stanley Capital International (MSCI) Emerging Markets Index is a free float adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI World Index is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries. Investors cannot invest directly in any index.The Russia Consumer Price Index or CPI measures changes in the prices paid by consumers for a basket of goods and services. Index performance does not reflect the deduction for fees, expenses, or taxes.
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