Analyst at Renaissance Capital
It is a dark time for emerging markets. Reform has been extinguished in Greece and flickers faintly in South Africa and Turkey. In Russia, Vladimir Putin, convinced that outside forces are seeking to destabilize his federation, plots his next move.
Investors rely on the sinister QE policies of central bankers. A new blow looms as the Fed prepares its assault on vulnerable markets, threatening turmoil as far as the galaxy’s frontier.
But all is not lost. General Buhari sweeps to victory in Nigeria, promising to strike rebel forces led by Boko Haram and escape the clutches of corruption. Little noticed but increasingly powerful, reform has awoken in Pakistan, Romania and Egypt, bringing hope to investors…
There will be more global excitement about the launch of Star Wars Episode 7: The Force Awakens, currently scheduled for release on 18 December 2015, than for the first Fed hike currently priced in for 16 December 2015. But we are excited by both. While we are purposefully avoiding leaks about the Force Awakens plot line, we’re paid to ‘leak’ what we think might happen around the next Fed hike.
Watching previous episodes is of limited use. It suggests that emerging markets (EM) do badly when US inflation is around 3% and the Fed is hiking to slow growth. The story this time is the Fed normalizing rates from emergency levels when CPI is still restrained, which is not quite the same. Fed hikes in 1994 hurt EM very badly, while normalizing rates after 2004 coincided with a strong EM performance until inflation picked up in 2008.
We cannot ignore the fact that EM has already been hit by the ‘taper tantrum,’ with a particular blow to twin-deficit countries such as South Africa and Turkey. EM looks cheap relative to developed markets (DM) now, in terms of both P/E ratios and exchange rates. That bellwether EM currency, the SA rand, is in its cheapest quartile of valuations since 1995 in REER terms. As highlighted in our global strategist Dan Salter’s piece on long-term investor returns (The Focal Point – Hindsight is a wonderful thing dated 13 April 2015), currency performance is one of the most important determinants of equity performance.
Asia, as the EM region with the greatest debt, has been the largest beneficiary of low US and global interest rates. For the same reason, peripheral European countries have been the greatest beneficiary of European Central Bank (ECB) easing. As US rates head higher, we expect the less-indebted economies of EM and frontier markets (FM) to fare relatively better, particularly those exposed to a recovering European Union (EU), and where some of their external debt is denominated in a weakening euro.
We believe the exceptions will be those countries where debt has risen too fast in the past decade. We are not surprised by the inclusion of high-debt Greece and China, but Brazil and to our surprise, Turkey, rival Greece for debt taken on over the past decade. Turkish private sector debt has soared from 19% of GDP in 2002 heading to perhaps 80% of GDP in 2016. This helps explain their president’s obsession with lower interest rates. It may also explain Turkey’s current weakness and leaves Turkey vulnerable to bigger problems in the medium term — perhaps around the time Star Wars Episode VIII is released in 2017. When we look at Georgia and Kenya through the same lens, we see them as potential candidates for the same level of concern in the medium and long term, respectively.
We see much greater scope for private sector credit growth to rise in a sustainable way in Egypt, and potentially Saudi Arabia, Qatar and the UAE over 2015-2016, as well, along with a host of our favorite FMs from Kazakhstan to Kenya, and from Romania to Nigeria.
If there is one ignored theme in our time zone, we think it is reform. In Egypt, Pakistan, Ukraine, Romania and Nigeria, new leaders in 2013-2015 are focused on change. Subsidies are being cut in Egypt and Pakistan. Prime Minister Nawaz Sharif’s privatizations are running ahead of those in reformist India (admittedly, Sharif started a year earlier). In Romania and Nigeria, new presidents have been elected on the back of anti-corruption promises. We expect a very capable team to be unveiled in Nigeria in the coming weeks, which we think could at best improve the country’s corruption rating by around 10 points by the end of 2016. Even Ukraine, beset by numerous challenges, is determined to accelerate reform.
Reform is also a missing theme when it comes to Russia, Turkey, Greece, the Czech Republic, Poland and SA. For Russia, Turkey and SA, we think this may because of the problem of political longevity that we published in 2013. The ruling power base has not changed in Turkey since 2002, in Russia since 2000, and in SA since 1994. It would be optimistic to expect radical policy changes. Their credit rating upgrade cycle has become a downgrade cycle as reform has petered out.
Having said that, we do expect Russia to raise the effective retirement age now that male life expectancy has risen from around 59 in 2005 to 65 in 2013. SA is investing in new power, even if that has come too late to avoid today’s power cuts. In Turkey, EU customs union discussions could result in agricultural reform. However, we think each country could achieve much more.
In EU member states, Greece’s government has an anti-reform bias that will count against equity investors, even if the country avoids default and Grexit. Hungary hints at radical reform in education and health, but this may give no benefit to equity investors, while it looks likely to drop previous reforms like its fiscal and debt rule.
We think Poland and the Czech Republic are resting on their rather good laurels. Both countries score very well when it comes to institutions, as we outline in the section on legal systems. These should be good investments for those who believe good institutions lead to good growth. That said, Poland’s 2015 parliamentary election might alter the country’s outlook.
Elsewhere in the legal system section, we outline that investors are paying up to twice as much to invest in equities in some countries (e.g., Bangladesh) as others (e.g., Pakistan), despite roughly the same quality of institutions in both. EU members since 2004, including Romania, tend to score very well.
The frontier report last year outlined the geography of the frontier galaxy with focus on demographics, democratization and education. This year report focuses on the good and bad — in both EM and FM. We look at credit growth, corruption and legal systems.
The primary conclusions are that reform is happening in our time zone, though not in the largest equity markets and it’s expected to result in markets pricing higher in Nigeria, Pakistan, Romania and Egypt than in their peers. Also see scope for oil exporters to experience something of a bounce back after being hit by the oil price fall.
Dan Salter is an analyst from Renaissance Capital. The view expressed here represents that of the Renaissance Capital team. This piece was previously published in the firm’s May 2015 Newsletter and was reproduced with permission. For additional information on emerging markets and frontier markets, contact the Renaissance Capital team.