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OPINION

Emerging markets trading close to book value

Emerging markets trading close to book value
April 23, 2020
Emerging markets trading close to book value

Some have argued that Ashmore is subject to excessive key personnel risk through an over-reliance on its founder and chief executive, Mark Coombs. But not too many investors would have had reservations over the locales it targets, given the MSCI Emerging Market index has delivered an average annualised total return of 9.2 per cent since its inception 30 years ago.

That rate of return needs to be set against a sub-optimal Sharpe ratio of 0.33, a pointer to volatile trading conditions in the wake of destabilising events such as the Asian financial crisis and the Russian debt default.

Logic dictates that investors will become more willing to accept increased risk of volatility in exchange for outperformance. But those risks will intensify if legislative trade barriers, rather than tariffs, are brought to bear against China as a result of the current crisis.

Parallels are already being drawn between the inaction and outright denials by Soviet officials in the aftermath of the Chernobyl nuclear disaster with those of the Chinese Communist Party following the Covid-19 outbreak in Hubei province.

Collectivist habits die hard, but whatever the political reality the outbreak has hardened anti-globalist sentiment, imperilling existing trade flows with China and other EM economies, particularly in areas deemed strategically important to national security.

It is no surprise that the proposal to give China’s Huawei Technologies a role in the development of the UK’s 5G mobile network is under renewed threat due to mounting opposition from rank-and-file Conservative MPs.

The reality is that structural changes under way already pose a threat to economies that have relied primarily on the comparative advantage afforded by low-cost labour. The theory exists that an ever-increasing utilisation of artificial intelligence and digital solutions will systematically undermine any unit labour cost advantages held by China and other lower-cost locales, giving rise to the further repatriation of industrial production and the shortening of supply chains. Original equipment manufacturers (OEM) and global logistics operators will be among the first to suffer.

Assumptions on the likely pace of EM growth were being recalibrated even prior to the virus outbreak. Per-capita growth rates have slowed appreciably. And for what it's worth, the International Monetary Fund (IMF) predicts that growth in Asian economies will stall at zero per cent in 2020. The IMF makes the point that China’s stimulus-induced growth rate was largely unchanged during the peak of the global financial crisis at 9.4 per cent – the country’s expected return of 1.2 per cent this year won’t be enough to prop up EM indices.

None of this means that the fast-growth regions of the global economy will suddenly lose their allure, but the outbreak (and its political consequences) demonstrate why it is unwise to rely on ingrained assumptions in investment matters. There is always a counter view. Even if these markets do feel the pinch due to a reorganisation of trade flows, countries such as China were already intent on diversifying their economies. The emphasis is on developing broad-based models by reducing reliance on exports in favour of domestic consumer markets.

Then there is the income angle. EMs have consistently delivered higher earnings than their developed counterparts, but these markets were not always synonymous with share-based returns. That is no longer the case and the average dividend payout ratio of EM companies is now 35 per cent. Spare capital is no longer automatically ploughed back into companies, so despite trade tensions with the US, China recorded dividend growth of 4.4 per cent on an underlying basis in 2019.

Current circumstances excepted, dividends tend to be more stable than earnings, so they offer a buffer against bottom-line volatility. It is also argued that stronger corporate governance is linked to higher dividend payouts, as they help to align the interests of shareholders with those of the companies in which they invest.

EM income funds still represent a smaller proportion of managed money than their western counterparts, so there is room for expansion. And Ashmore makes the point that EM equities are now trading at a lowly average of 1.1 times book value following the sell-off, the same level as seen in the financial crisis.