Emerging market equities have rallied by over 90 per cent in local currency terms since their trough in October 2008. Vivacious economic fundamentals stood in stark contrast to much of the developed world.
The hammering taken by emerging market stocks through the credit crunch was much more about historic beta than fair value and much of the price recovery last year was about beta too.
That is unlikely to continue and asset allocators will need to be more judicious in their country selection to accrue similar outperformance.
The emerging market leadership has now changed and stockmarket fundamentals are now coming back to the fore. Year-to-date performance suggests that emerging market countries with the best earnings’ revisions are now most likely to outperform.
That is probably just the beginning, given that emerging markets are now trading at a much narrower price/ earnings’ discount to the US than has been typical.
Consensus earnings’ numbers are being revised up very slowly into recovery and the average emerging market country is still expected to grow corporate earnings by less than the US over one to three years. We think that will change and investors are banking on that too, given that the best performers have also tended to have the highest p/e growth ratios.
Stockmarket and economic fundamentals are much more than earnings’ expectations and emerging market countries with strong fundamentals typically have savings and current account surpluses.
Asian current accounts are in rude health, giving their governments unrivalled flexibility to build the capital stock, encourage citizens to consume and increase both potential and coincident GDP (and corporate earnings).
In the late 1990s, these nations’ savings were woefully insufficient to finance investment activities so when foreign portfolio flows dried up, economic growth collapsed.
Today could not be more different – at the end of 2009, Malaysia, China and Taiwan had current account surpluses over 9 per cent of their GDP.
The latest Chinese export data adds much weight to the argument that global trade is recovering. Although we wish to leverage this theme in our portfolios, our favoured emerging market picks plug into domestic demand stories that are even more compelling.
As a nation develops, it should reduce its dependence on exports as income rises and the export share of GDP should cede to domestic consumption. Contrary to popular perception, China’s gross exports, calculated as a percentage of nominal GDP, average just 27 per cent over the last ten years with a visible trade balance of just 4 per cent.
This compares to respective figures of 96 per cent and 18 per cent in Malaysia and 33 per cent and 6 per cent in Germany.
Since 1990, China’s trade balance, on average, has contributed just 10 per cent of total nominal GDP growth, in Germany, trade contributes around 20 per cent.
In China, capital formation and the private consumption expenditure have been driving growth, with the former trending up in recent years. Remembering the mountain of household savings, this is great news, especially when we consider the surge in state welfare expenditure initiated last year as a way to encourage consumers to spend.
It is these kinds of fundamentals that attract us as investors to the China growth story but if that were not enough, investors may soon enjoy an added Asian currency kicker. China does not want to constrain growth by importing inflation but catalysing a transfer of wealth to the consumer would further cement its dominant position in the global economy and ensure domestic demand.
In the absence of an overwhelming competitive disadvantage, we suggest that appreciation is likely and a domino effect will occur throughout the region.
Robert Jukes is global strategist at Collins Stewart Wealth Management