Far from up against a wall
By Tom Stevenson, Investment Director 
As we close out the first quarter of 2017, financial markets have once again shown their capacity to wrong-foot investors. During the first three months of the year, contrary to conventional wisdom, the top-performing stock markets have not been in the US, not even in a resurgent Europe, but in the emerging markets.

In aggregate, stock markets in the developing world have risen by about 12pc since the start of the year. That’s twice as fast as Wall Street, which itself has done twice as well as London. This wasn’t in the script following Donald Trump’s election on an America First, protectionist ticket. Emerging markets should have been first up against the wall.

The two reasons commonly cited for emerging markets’ expected underperformance were Trade and Taper. Emerging markets have prospered on the back of an open, global system of minimal tariffs and free trade. Rolling back that tide might be expected to hit the developing world hardest.The experience of 2013’s Taper Tantrum, meanwhile, suggested that rising US interest rates would be bad news for countries with high levels of dollar-denominated debts and a dependence on commodities, which tend to fall in value as the US currency rises.
In fact, Trump’s rhetoric on free trade has (so far at least) been more talk than action. And the dollar, far from strengthening, has actually weakened against most other currencies, notably those in emerging markets. The headlines about the fall in the South African Rand in recent days have tended not to mention that it remains 20pc stronger against the dollar than it was last May.
The shambles of the Zuma government is a reminder of why investors typically place emerging markets in the ‘risky’ bucket while considering developed markets as ‘safe’. Recent developments in countries like Turkey and Venezuela confirm that anyone investing in these markets needs to do so with their eyes wide open.

But the events of the past nine months in Britain and America show that the discount that investors typically attach to emerging markets might just as sensibly be applied to the developed world. A two-speed political and corporate governance model may have made sense 20 years ago but it looks anachronistic  in light of Brexit, Trump and this year’s string of unpredictable European elections. Indeed, the emerging markets that dominate investors’ thinking about the asset class, China and India, are relative paragons of stability and predictability. China’s system of five- and ten-year plans ensures there are no surprises. In India, too, the recent electoral success and popularity of Prime Minister Narendra Modi mean investors can make long-term plans around his multi-year reform programme in a way that US investors can only dream of.

Who knows whether President Trump will be any more successful with his proposed tax reforms, deregulation and infrastructure spending programme than he was with his botched replacement of Obamacare? In the meantime, investors can only hope for the best and prepare for the worst. Should emerging market investors be concerned about the twin threats of Taper and Trade? Dealing with monetary policy first, history suggests that emerging markets actually do relatively well in an environment of gently rising interest rates. This is because rate hikes reflect stronger global growth in the early stages of a tightening cycle, which is good for all markets but particularly those in the developing world.

Trade is certainly the bigger worry. But, here too, the concerns are probably overstated. There are three reasons why a trade war is unlikely. First, Trump’s power is quite limited. Any China-specific tariffs would simply see jobs move to other countries like Vietnam where Chinese companies have already moved to capitalise on lower wages.

Second, the imposition of import duties such as the mooted border tax would simply push up costs for US consumers and these would hit hardest the very people that voted Trump into power. Finally, China would simply retaliate, hitting sales of big US employers like Boeing and General Motors which are major exporters across the Pacific. Protectionism won’t bring jobs back to America; it will destroy them.

So perhaps the performance of emerging markets this year is not so surprising after all. And neither are the fund flows into the asset class, their strongest on record, according to Morgan Stanley. The structural growth story in emerging markets remains intact. Living standards have grown steadily during the past 20 or so years even as wages have stagnated in real terms in the developed world. On a recent trip to India, one of my colleagues reported seeing coconut traders by the side of a road accepting digital payments via their customers’ mobile phones. Trump talks about spending $1trn on infrastructure over ten years. China has spent the same on roads, rail, bridges and telecoms in a single year.

And it’s not just a demand story. China has shut down 50 million tonnes of steel capacity in the last year alone. Even state-owned companies, the much maligned drag on the Chinese economic miracle, are starting to behave like proper businesses. Baosteel will have to become among the most efficient steel producers in the world if its management are to exercise their share options. 

Quite often in investment, the interesting story happens while you are looking the other way. The past year has all been about the developed markets in America and Europe. Meanwhile, the ongoing shift of economic power is playing out in the stock markets of Asia, Africa and Latin America. And it’s not too late. Despite flickering back to life in the past year, emerging market shares are no higher than they were in 2009 and something like 25pc cheaper than in America. After nine months of navel-gazing, it’s time to look further afield, I think.


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