Our constructive view on EMs is based on their very attractive fundamentals. However, the EM playbook is complicated. There is a risk we have to deal with ‘higher for longer’ over the medium term, even when we are seeing inflation peaking and rolling over, normally an indication to return to EMs given easing liquidity and a weak US dollar.
We believe we are on the brink of a new EM upcycle and that EMs can easily adapt to the ‘higher for longer’ scenario, likely reflected in improving fundamentals as part of a Fed easing cycle. However, we will be more than compensated by the level of discount rate already priced in and better growth and debt dynamics. We believe we are entering a multi-polar world in which many EM countries and companies can do very well, offering more of an opportunity than a risk.
What is going on the US fixed income market and where does it leave EMs?
It is not usually easy for EM equity investors to be smart on the US fixed income market. However, having invested in EMs for over 20 years, we have spent a fair bit of time on US monetary policy and its link to EM asset pricing. Over the years, we have learned the hard way that the Fed rate cycle, the 10-year Treasury yield and the US dollar have significant influence on the EM asset class. However, we believe we are at an inflection point, that the asset class is moving towards independence in this increasingly multi-polar world, and that economic growth and better debt dynamics will eventually reflect asset pricing more appropriately.
We believe a new component is entering the equation which will add a layer of complication, namely the term premium. In our original forecast, dating back to the early spike in inflation coming out of the Covid period, we expected that both US monetary and fiscal policy would normalise relatively quickly which would, with the usual lag, lead to a normalisation of the demand and supply sides of the economy. This would more or less get us back to square one and we would be back in a world of structural, relatively low inflation once again, and the old deflationary forces of technology and debt we experienced in the decade following the global financial crisis until Covid.
One could, at the more structural level, posit that events in 2H18 might have fundamentally changed our old inflation picture, rendering the above scenario of going back to the low inflation world overly simplistic and almost naïve. We acknowledge this essential question in relation to EMs and their longer-term performance.
The US/China trade war and China’s labour force numbers peaking, which officially began in 2H18, certainly had an impact on goods inflation, changing the dynamics here forever. However, we believe workarounds and new manufacturing hubs will offset China’s reduced scale benefit to a large degree over the medium term. Also, other deflationary drivers will increasingly reduce inflationary pressures, fears of which have mounted on predictions of a less-globalised world. Technology is the key driver here, as well as new pools of cheap labour.
The trade war and geopolitical tensions between China and the US have not had as significant an impact on goods inflation as feared.
The trade war and geopolitical tensions between China and the US have not had as significant an impact on goods inflation as feared. Even the highest risk areas such as technology, where the US has hit China hard with sanctions, have seen the usual cost curves play out. Admittedly, the current weak demand cycle has played a role but we have not seen a structural change. In aggregate, China is now exporting deflation to the rest of the world in everything from solar panels to cars. We are impressed with how fast we have seen new manufacturing hubs being developed in countries including India, Vietnam and Mexico – three countries we see as the big winners from the so-called ‘China Plus One’ strategy being adopted by most western firms outsourcing manufacturing. Dual-sourcing, cost levels, local demand market developments and a Chinese labour force peaking had all made this structural trend emerge long before the US/China tension. A case in point is Samsung Electronics, which has been building up its manufacturing in Vietnam over the past decade. The trade war and Covid-related supply issues have simply fast-tracked this trend.
We do not expect India et al to become fully competitive with China overnight but it is important to keep in mind that when we are talking about manufacturing in, for example, India, this is not three guys in a garage trying to make a manufacturing line for Apple. Rather, this is Apple working closely with current key suppliers and manufacturers (from Taiwan), together with local, deep-pocketed, smart industrial conglomerates alongside strong government support. As such, we believe global investors and consumers will not suffer over the medium term from the China Plus One move, from an inflationary perspective. On the other hand, this is a massive new investment opportunity and as stock-pickers we are extremely excited by these new decade-long investment themes emerging in our part of the world.
Having explained how deglobalisation can be managed, this brings us back to the US and the inflation cycle. Monetary policy works with a 12-18 month lag and we have just passed the 12-month mark since the first yield curve inversion; we believe we are getting to the point where monetary tightening will really start to bite. Looking at the trend in US inflation as well as economic data points such as the average interest rate now applied to small and medium-sized enterprises (SMEs) for working capital loans, or the latest job data, we are confident that monetary policy is doing its job. If anything, we see a higher risk of overshooting on the downside rather than not being able to deal with US inflation.
The only really difficult part for US inflation, as we see it, is the shelter component. However, looking at front-end data like the Zillow Rent Index, we believe this will also normalise though with a longer lag. As a side comment, and acknowledging this is less important, inflation is almost collapsing in Europe. That leaves us with inflation in EMs and we see, in general, conditions consistent with well-managed monetary and fiscal policies.
EM central banks, by and large, implemented tight monetary policy ahead of the Fed and with a larger magnitude. At the same time, there were no free fiscal gifts as was the case in the US and Europe.
Here is the essence of the current inflation debate and, in particular, the US 10-year Treasury yield and the ‘higher for longer’ scenario. US fiscal policy has prompted a supply issue in the Treasury market, and the development of a term premium.
The fiscal balance in the US is starting to look like that of the weak EM countries in the bad old days when we constantly talked about “twin deficits” for key EM countries.
The (un)willingness to hold US Treasuries as a foreign institutional investor is already starting to show, with some of the largest surplus countries significantly reducing their holdings.
Clearly, geopolitics are also at play here and the US confiscating Russian assets on its invasion of Ukraine sent a signal around the world – we think it was the right thing to do – however, the US clearly needs to do everything it can to re-establish trust in its Treasury market which it has not done yet.
We are not arguing for a Treasury market out of control and can see good local US demand at these levels but, with reduced foreign participation, the issue of a larger term premium comes into play, in our view. The same argument can be made around the US dollar.
The key question is what happens to EMs if monetary policy eases as inflation starts to move closer to its target level, but the 10-year Treasury stays around 5% or, as some market observers indicate, moves even higher. We believe EMs can not only survive such a move but easing monetary policy will provide a significant upside to most EMs, assuming we avoid some form of black swan event in the US Treasury market.
EMs are already pricing in a very significant risk premium, particularly for growth companies, as we have seen a significant multiplier contraction on duration risk. A high global discount rate is already in the price, as we see it. However, what is not in the price for EMs is the room to start a significant monetary easing cycle. We believe that as soon as the Fed moves, many EMs will follow but, because of much better debt dynamics and higher savings rates, this will lead to a new strong investment and earnings cycle. Given we are coming out of a period when most EM countries have been in a low investment cycle with tight monetary and fiscal policies, we see a significant upside, driving growth and earnings. Starting at low valuation levels, we believe this offers an attractive risk/reward opportunity.
Can EM growth equities perform in a ‘higher for longer’ rate scenario? Can a new investment and earnings cycle play out on this part of the risk spectrum, if we still have a US 10-year yield at decade-high levels? We believe they can, looking to the EM fixed income market and ‘Magnificent Seven’ US technology stocks.
Recently, the fixed income market has been willing to upgrade EMs significantly. We have also seen the Magnificent Seven materially outperform the broader market, even in a rising discount rate environment. Why? Growth, returns and cash on the balance sheet seem to meaningfully override a higher market discount rate.
This is precisely what we believe can, and will, happen to EM growth stocks. The fixed income markets have clearly signaled they are comfortable with the relative debt dynamics in EMs and the relative risk premium is not a concern. We need to demonstrate that we can have high quality growth companies with strong cash balances coming back into higher growth mode. If that is the case, we see the potential for the earnings cycle to kick in and for risky return-seeking capital to return.
Outlook
In our view, the catalyst for this new investment and earnings cycle in EMs will be monetary easing. However, the high savings rates and structural dynamics in areas such as urbanisation and manufacturing (China Plus One) will give the coming upcycle longevity for key countries and industries.
From a country perspective, we see attractive fundamentals among the Association of Southeast Asian Nations (ASEAN), particularly Vietnam and Indonesia. We find Mexico increasingly attractive and are seeing interesting companies there; we find Brazil positively exposed to an easing cycle, also offering cheap growth companies. Despite the current conflict in the Middle East, we believe there is a strong domestic investment cycle coming in Saudi Arabia and the UAE, as they are now recycling capital into their domestic economies. We also believe India will continue its strong structural growth and we could even see an increased investment cycle, as a number of current projects are so-called ‘brownfield expansions’, and we have not yet started to see the big greenfield projects starting. China will see significantly lower growth rates going forward, but the move away from growth at all costs will lead to an opportunity for good earnings per share (EPS).
We believe we are facing a new, large technology up-cycle in which artificial intelligence (AI) will be a key part of the renewed level of investments.
We also see a strong technology up-cycle coming back, starting with memory (semiconductors) and foundries, which will benefit the technology sector in South Korea and Taiwan. We believe we are facing a new, large technology up-cycle in which artificial intelligence (AI) will be a key part of the renewed level of investments. Even though we do not have a company such as NVIDIA in EMs, we do have a number of key companies in that supply chain where there will be strong AI exposure at attractive valuation levels.
We are fundamental investors, focusing on using our expertise to give responsible returns in EMs. We believe we work with a unique, sustainability-integrated economic value added (EVA) framework and valuation methodology that has given us a strong performance track record over our time as EM investors. Applying this EVA valuation framework in the current environment excites us, as there are a number of great companies that are growing, with an attractive ROIC/WACC spread (with our WACC directly impacted from the 10-year US yield) that are mispriced, in our view. Combined with a monetary cycle that is turning, we believe this will set us up for attractive responsible returns even in a ‘higher for longer’ world, as fundamentals eventually prevail.
