Equities
Is the Great Emerging Market Growth Story Over? Q&A with Justin Leverenz, Director of Emerging Market Equities Justin Leverenz, CFA, SVP, Director of Emerging Market Equities, Portfolio Manager
Q Emerging Markets have underperformed the rest of the world since the financial crisis. Do you believe that this trend will reverse? A Emerging market equities look like they have bottomed. Valuations are as attractive as they have been in a very long time following a prolonged period of weak absolute performance and relative underperformance compared to other parts of the world. Exhibit 1 Many economies appear to be stabilizing. In China, the real economy is starting to recover. The industrial sector had been in a deep recession and is still fragile but it is improving. The property market is improving as inventories have come down a lot and prices are up in many cities. The consumer sector continues to be vibrant. The rule of large numbers suggests that we can’t expect China to once again experience growth at an 8%–10% clip, but China will continue to be the world’s largest contributor to global growth for a very long time. Most importantly, going forward we expect emerging markets to trade less on macro conditions and more on business fundamentals and growth prospects. There are a number of extraordinary companies in the emerging world trading at very attractive opportunities. That is always what excites us most.
Exhibit 1 Emerging Markets Had Underperformed for an Extended Period, Valuations Appear Attractive Index total returns (%, in USD) 250
MSCI Emerging Markets Index price-to-earnings ratio
■ S&P 500 Index ■ MSCI EAFE Index ■ MSCI EM Index
200
14.5x
14.0x
13.5
150 12.5
11.8x
100 11.5 50
0 2009
2010
2011
2012
2013
2014
2015
10.5
Feb-16
20-Year Average
Source: Bloomberg 2/29/16: U.S. equity represented by S&P 500 Index, developed international represented by MSCI EAFE Index, emerging markets represented by MSCI EM Index. Past performance does not guarantee future results. For Institutional Investor Use Only
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Q How have emerging markets transformed over the past few decades?
The emerging market bull market from 2003 to 2007 was part of the legitimate growth phase. The period was highlighted by China ascending to become the largest exporter in the world and
A The emerging market growth story of the past
embarking on massive real estate investment
decades has occurred in distinct phases. The
following decades of neglect. The huge expansion
initial phase of growth occurred as a confluence
of Chinese real estate was spurred by enormous
of factors, including the opening of economies to
demand as families moved from small dwellings
global markets, the privatization of state assets,
with shared toilets and communal kitchens to
better fiscal and monetary policies, and financial
homes that better fit their needs. The implications
market liberalization to name a few, unleashed massive productivity gains from previously underemployed workers. Social mobility followed at a rate never before seen in world history, highlighted
for the commodity markets and the commodityproducing countries of the world were significant. The next phase of the bull market (2010–2013)
by nearly 700 million people moving out of
occurred in the aftermath of the global financial
poverty in China alone. The results of realizing the
crisis and was less premised on fundamentals
economic potential of the emerging economies
than on leverage. As global trade slowed
were stunning, as the economies in aggregate
significantly, policymakers, particularly in China,
grew at a rate of 4.5 times that of the developed
took unconventional steps to support growth to
world for two decades. Today, emerging markets,
unintended consequences including massive
at purchasing power parity, represent more than
misallocation of resources and the build-up of
half of the world’s economic activity, up from
excess capacity in many industries. Commodity
one-third of world gross domestic product in 1980.
prices suffered as too did the commodity-
Exhibit 2
producing countries of the world.
Exhibit 2 Emerging Markets Now Represent More than Half of World’s Economic Activity Share of world GDP (purchasing power parity) 70%
■ Emerging Markets ■ Developing Markets 60
50
40
30
1980
1985
1990
Source: International Monetary Fund, 12/31/15.
2
1995
®
2000
2005
2010
2015
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Q Using China as the example, what are the promised structural reforms and how confident are you that Chinese policymakers will deliver on their promises?
Going forward, emerging markets will continue to be a much larger contributor to world growth than the developed world. Demographics are in their favor and the potential to unleash further productivity gains from an ever-evolving work force remains. Exhibit 3
A So far we have been disappointed. In the Third
There will be low growth on the industrial side
Plenum of its 18th Party Congress in 2013,
everywhere in the world. There is simply too
Chinese policymakers outlined proposals to boost
much excess capacity and not enough capital
competition and economic efficiency. The reform
formation. In many places it will require policy-
agenda in part included plans to reform state-owned
makers to proceed with promised structural
enterprises, to liberalize rules on market access
reforms to reorient growth and to address
and foreign investment, and to elevate the role
domestic vulnerabilities.
of the market in allocating resources in the economy.
The excitement is in the service sectors. Within
Almost none of it has happened. The policy lacks
that we are interested in sectors and industries
coherence and priority. The same can be said
with dynamic change and real value being
of policy reforms in countries like Indonesia and
extracted including e-commerce, online video
India. For example, Narendra Modi took office in
and mobile gaming, cloud computing, travel,
India to high expectations from the market and has
and Internet services like ride hailing.
thus far accomplished very little.
Most importantly, the next phase of growth in the global economy will be tied more around innovations and business models and less on countries. I can’t stress this enough.
Exhibit 3 Emerging Markets Have Demographic Tailwinds Growth of maturing working age population (aged 35-54) by select country estimate 2015-2030 80% 60
■ Emerging Market Countries
■ Developed Market Countries
40 20 0
Egypt
Nigeria
Philippines
Vietnam
South Africa
Argentina
Turkey
India
Peru
Brazil
Mexico
Poland
Chile
USA
Indonesia
Canada
U.K.
China
France
Spain
Germany
Italy
–40
Japan
–20
Sources: U.S. Census Bureau and Ned Davis Research, as of 12/31/15.
3
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Monetary policy can’t do it all. Countries need microeconomic reform. For example, savings rates will remain high in most of Asia as the Asian governments have not established welfare and healthcare systems. China has national healthcare but it doesn’t offer a lot. Many countries also need
Q You mentioned the credit excesses in China. Will the Chinese banking system ultimately have to be recapitalized and how will that unfold? A The short answer is that it will have to happen but no one knows how it will unfold.
true honesty about the credit excess in countries
The good news for investors is that the current
like China and India.
credit problems in China will not result in a
That said, we deal with the world as it is presented
global financial crisis even as the volume of
rather than as we would like it to be. We are always
non-performing loans on bank balance sheets
asked macro questions but spend 95% of our time
increases. For one, Chinese banks are well
identifying companies with extraordinary growth
funded. Reserve rates are very high compared to
models, true sustainable advantages and pricing
the rest of the world. Savings rates in China are
power. The market may be overly focused on
also very high compared to the rest of the world
macro conditions today as it was in prior periods
so deposit-to-loan ratios at the banks are also
like 1996-1998. In our opinion this will change,
very healthy. In addition, there is no net foreign
and investors will once again focus on companies
leverage. China is a net foreign creditor to the rest
and not countries.
of the world. Exhibit 4
Exhibit 4 China Is a Net Creditor to the World Net international investment position: largest creditor countries $3,200
$3,009
2,400
$1,539
1,600
$663
Sources: Bloomberg and International Monetary Fund, 9/30/15.
4
Switzerland
Norway
Hong Kong
China
Germany
Japan
0
$531
$527
$310
Russia
$737
800
Netherlands
$934
Singapore
$ Billions
$1,634
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Still, the situation is delicate and will require
unbelievable relative to anything in our lives. In
courage and appropriate policy. If we use the
the U.S. we grew up with cable television, motion
example of the 1990s, the last time the Chinese
pictures, and malls. China doesn’t have any offline
had to recapitalize their banking system, then
competition. For decades, entertainment content
the problem will ultimately be resolved through
in China came down to the two choices of limited
some combination of government investment,
or none. Former retail was done really poorly.
restructuring of loans, debt write offs and
The Internet is the out from decades of oppression
the transferring of troubled loans to asset
and limited choice.
management companies.
E-commerce is already bigger in China than in
China has the capacity to deal with its banking
the U.S. In 2014, China’s e-commerce market
issues. The time frame will depend on many
reached $426 billion, or 10% of total national
things. Unfortunately, Chinese policymakers
retail sales. This contrasts with the United States,
appear committed to do what is needed to support
which despite being the world’s largest consumer
growth in the near term, instead of promoting long-
marketplace, posted $305 billion in e-commerce
term sustainable growth. The massive injections
merchandise value, or approximately 7% of total
of capital are not translating into true performance
national sales.1 In 2014, China’s e-commerce
in the real economy and are only delaying the
gross merchandise volume grew 32% compared
inevitable restructuring that must commence.
to the U.S. which grew only 16%. Exhibit 5 Similar leapfrogging is evident in Internet media
Q What is it about the emerging world that gets you excited?
and content (online video, mobile gaming), verticals (travel, classifieds) and Internet services (ride
A Many things.
hailing, online-to-offline). There are tremendously
Let’s start with the Internet. Spend time with any 25-year-old in China and consider the importance of the Internet in their lives. The significance is
innovative Chinese companies with sustainable advantages in industries like e-commerce or online gaming that are growing at tremendous rates.
Exhibit 5 China Internet Use and E-Commerce Growing Rapidly % of Chinese population using Internet
Chinese online sales as % of total retail sales
50%
18%
16.6 15.5
40
13.8 14
12.0
30
10.1
20 10
8.3
10
0
1993
1997
2001
2005
Source: National Bureau of Statistics of China, 2015.
2009
2013
6
2013
2014
2015
2016E
Source: National Bureau of Statistics of China, 2015.
2017E
2018E
5
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Next, consider the hierarchy of consumer needs.
A Most of the currency weakness has been c entered
Our portfolios will express themes like growing
in the commodity-producing countries. The
consumer demand for cosmetics and skin care,
currencies of the commodity-producing countries
education and travel. But it is not just getting
like the South African rand and Chilean peso
the themes right, rather it is about expressing the
depreciated significantly and now appear to
themes through companies with pricing power
be undervalued.
and brand differentiation. A good example is Ctrip,2 the leading provider of travel services in China, which now has in excess of 80% of the
The currencies of the manufacturing countries of the emerging markets like the Korean won and the Chinese renminbi have depreciated less and
travel gross merchandise value in China and should see a significant expansion in the number of customers signing up, operating margins,
may continue to decline modestly against the dollar but we do not believe that currency moves will be dramatic.
and returns through time.
Concerns over a large-scale renminbi depreciation
There is no shortage of exciting investable
are vastly overstated. All the scary headlines miss
opportunities.
the fact that the renminbi has been the world’s
Q Much of the weakness in emerging market equities has been driven by currency weakness. Do investors run the risk of getting the investment themes right but experiencing poor investment results when the returns are translated back into dollars?
strongest currency for the past decade. China’s problem is not a currency problem. China is already responsible for 20% of the manufactured goods purchased by the world. In fact, China’s trade surplus has actually expanded recently. Some of that is the result of the declining cost of commodity imports but much of it is China gaining comparative advantages in many industries. Unlike Japan, for example, China has no need to become a beggarthy-neighbor country. Exhibit 6
Exhibit 6 Chinese Renminbi Has Been Among the World’s Strongest Currencies Select emerging market currencies per U.S. dollar
Values in Inverse Order
250
200
150
■ Chinese Renminbi ■ Chilean Peso ■ Peruvian New Sol 100 Sep-14
6
Source: Bloomberg, 3/11/16.
■ South African Rand ■ Thai Baht ■ Korean Won Mar-15
■ Brazilian Real ■ Russian Ruble
Sep-15
Mar-16
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The pressure to depreciate the renminbi had
environment has prices for Russian equities
stemmed entirely from the extreme strength of
trading at extremely attractive levels. There aren’t
the U.S. dollar, against which China maintains
many quality companies in Russia but we have
a quasi-peg. For all the hand wringing over a
identified some great opportunities like Novatek,2
looming Chinese currency devaluation, the
a producer and transporter of natural gas and liquid
renminbi fell only 1.5% from its early 2016 peak
hydrocarbons, and Magnit,2 Russia’s largest retailer
through March to date.3 Capital outflows have
and the world’s fourth largest retailer. We have
recently slowed as Chinese policymakers enforce
held [both companies] for years and maintain great
capital regulations that limit or prevent capital from
confidence in their management teams and in the
being transferred overseas.
sustainability of their business advantages.
Q We’ve spent a lot of time talking about China. What are your views on other countries in the emerging world?
India receives great press in the U.S. but has been a challenging place for human outcomes including nutrition, standards of living, and education. The country is still poor and continues to rank amongst the worst countries in the world as a place to do
A While we have many opinions on the macro
business. India, like China, also needs to recap
environment, our focus is on investing in
italize its banking system, most of which is owned
exceptional companies. To address your question,
and operated by the state. That said, India is a
I would answer that everywhere has promise but
great example of a country where the macro
challenges as well.
environment is less relevant to investors. There is
Brazil, for example, remains a closed economy
great innovation in the healthcare and information
with low productivity and low social mobility. Brazil
technology sectors. There is also strength in the
had a gift of a decade of high growth but savings
private banking sector. One of our top holdings is
rates never increased and fixed capital investment
Housing Development Finance Corporation
remained low. The old issues of corruption and
(HDFC),2 a private financial conglomerate that at
inflation remain a problem. Fortunately, the
its core is a mortgage business with very high
independent press and independent judiciary
asset quality, lending standards, and governance.
appear to be addressing corruption problems.
HDFC also operates an extraordinary commercial
Brazil has the tools to effect change in the country
bank that stands to take significant market share
so there is hope over the long term. There are a
as its state-owned competitors don’t have
handful of great companies in Brazil including
the capital or the capacity to fund the Indian
Embraer and BM&FBovespa.2 We are also invested in a few companies that are benefitting from the structural growth in retail and education.
growth story. As always, we continue to look for exceptional companies with great businesses and
Russia has been plagued by crashing commodity
comparative advantages. These exist all over
prices, poor governance, and worsening demographics. We believe that commodity prices won’t be persistently this low. The supply curves
the emerging world.
suggest that we won’t be able to deliver the commodities at these prices. The weak macro
7
Justin Leverenz, CFA SVP, Director of Emerging Market Equities, Portfolio Manager
Justin Leverenz serves as portfolio manager of the Emerging Markets Equity strategy. Additionally, he is Director of Emerging Market Equities for the firm.
1. Source: U.S. Census Bureau, 2015. 2. The mention of specific companies does not constitute a recommendation by any particular fund or by OppenheimerFunds, Inc. As of 12/31/15, Oppenheimer Developing Markets Fund had 2.56% of its assets invested in Ctrip.com Intl. Ltd; 1.34% invested in Embraer S.A.; 0.98% invested in BM&F Bovespa; 2.09% invested in Novatek OAO; 3.14% invested in Magnit PJSC; and 4.55% invested in Housing Development Finance Corporation. 3. Source: FactSet, 2016.
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