Thanks to nominal growth, marginal expansion, and higher returns on investment capital, emerging markets are experiencing a serious upswing.
Coming from a period where real growth was disappointing across the board, emerging markets (EM’s) must work hard to gain their momentum back. The heavy investment inflow they incurred during the financial crisis caused them to lose their pricing power, consequently lowering demand and causing deflation. But a lot of these factors are about to turn around. With EM’s experiencing a cumulative 12 percent revenue growth, there is evidence that the journey has begun.
However, not all EM’s are created equal. “Global growth will be driven by Asia in the years to come because it is absolutely the fastest growing region amongst global EM,” says Jorry Rask Nøddekær Portfolio Manager with Nordea Asset Management and Head of Emerging Markets. “Our expectations for Asia are a lot higher because we think there is a lot more room to grow.”
When referencing Asian EM’s, China and India inevitably garner most of the attention because the data commands it. The Organisation for Economic Co-operation and Development (OECD) projects the Chinese and Indian nominal GDP growth rates of 2018 to be 8.7 and 12.3 percent respectively. Compare this with the United States’ projection of 5.4 percent, and it is easy to see why Nøddekær believes China and India have “depth and breadth for improvement and a lot of very exciting investment cases.” Both Xi Xing Ping and Narendra Modi are pushing great reforms through their governmental bodies, helping to significantly reduce the overt economic stress felt by the Asian continent in 2016.
For a comprehensive macro view, Nøddekær breaks the positive outlook for EM’s down to satellite and helicopter views. From a satellite view, attractive demographics, bursting populations and millions more middle class spenders with disposable incomes are propelling urbanization and the service driven sectors of the market economy. Productivity gains are facilitated by increase in efficiency and output due to the implementation and adaptation of technology throughout diverse industries. To top this off, corporate governance is now taken more seriously by these EM companies, and ESG factors are gradually becoming easier for them to integrate into their operational processes.
Of the three long-term structural growth areas for EM that team has identified, technology shows the most potential. Nøddekær shows a general sense of excitement about the industry as a whole. “These companies have high return on investment capital, clean balance sheets and cheap absolute valuation levels,” he says. The other two themes, healthcare and consumer goods, are directly linked to the demographic and population factors. Taking stock of the potential in India, China, South Korea, Taiwan is highly valuable.
From a helicopter view, EM stocks are excessively cheap due to the long period of poor performance. Foreign exchange headwinds are also reducing, providing another welcome break for EM’s. The strong U.S. dollar hit the nominal consumption in the EM’s hard, but this is beginning to wane. EM foreign exchange is priced low and U.S. dollar debt has been reduced.
For Nøddekær, a real breaking point came last November when China’s producer price index (PPI) data was positive for the first time, gaining 3.3 percent. “Six months earlier, it was evident that they were taking the steps to achieve economic growth in a cleverer way by focusing on the reality of supply-side performance,” he says. “This entailed addressing the excess capacity of steel and coal that was artificially forced into the value chain. Because of this, China is now experiencing nominal returns with nominal pricing power.”
The fact that EM companies are beginning to see nominal growth again is another encouraging sign, because after all, we are still living in a nominal world. “Everybody is obsessed with the Chinese real GDP numbers, but in reality, nominal numbers are a much more important measurement. This is how companies experience growth, they are the prices that consumers see, and it is what drives the economy,” emphasizes Nøddekær.
For a final bit of positive imagery, Nøddekær insists that EM markets have begun a “harvest period”: with margin expansion at the top and the bottom, investors can cut revenue and gain access to free cash flow. With expected generation predicted to increase in the next two years in Asia, it’s time for investors to sharpen their sickles.