Emerging Markets At A Turning Point

[This sponsored article was first published in the September issue of ETF Report UK, our quarterly magazine for UK financial advisers]

Many feel that emerging markets are at a turning point in the wake of China's slowdown. WisdomTree Europe director of research Viktor Nossek has some advice for investors looking to navigate the new landscape.

ETF Report UK: What is the general outlook for emerging markets? In particular, what's happening with monetary policy and fiscal stimulus in those markets right now?

Viktor Nossek: At the center is China, and China is looking to do whatever it can to prevent a hard landing and instigate some degree of soft landing in the economy. It feels compelled to use unconventional policy tools that may actually trigger geopolitical tensions in and around the region, as it already devalued the RMB significantly. This is evidence that the slowdown is deepening at a rate that is too uncomfortable for officials to accept. I think the Chinese officials are well aware that there's a slowdown unfolding, but it's all about how you manage the slowdown.

It's not that they're trying to reinvigorate growth. They're aware of the leverage existing in the system, both financial leverage and the operating leverage that is in the process of being unwound. As a result, the slowdown is inevitable. But it needs to be a managed slowdown. The devaluation of the RMB has essentially come as a result of conventional policy tools not really working to help exporters to normalize. We've seen an export slump unfolding. And if you compare those rates of decline to the period during the financial crisis, they're pretty similar.

This has really spooked the Chinese officials. They believe they need to manage this slowdown in exports a bit more carefully and give the export space another shot in the arm by loosening the trading band on the RMB. The spillover effect now is that other trading partners of Asia have a strong sense that they could also devalue their currency. The whole region is very much driven by trade. I'm looking at countries such as Japan—the second or the third largest trading partner of China—which already instigated the quantitative easing, and has helped sharply devalue the dollar. Japan may actually feel compelled to accelerate quantitative easing on the back of that to help their exports be more competitive with China.

I think the geopolitical tensions should be rising as a result of this. And the equity risk premia should also rise, which means there should be further selling pressure on Asian equities, short term.

ETF Report UK: What individual countries or sectors in the emerging market space present an opportunity?

Nossek: I think the story should be around, where is yield to be had? Is it in equity or is it in bonds? Also in the equity space, you want to be focused on growth or on value. It is really China's slowing growth that has spilled over everywhere else. The opportunities should be within emerging markets around style. Previously, it was growth themes such as small cap equities that were seen as the new way to gain maximum exposure to strong growing emerging market economies. Now, I think the focus should be more on the defensive sectors, or the sectors and themes around emerging markets where there is 
relative safety to be had and where you can get yield.

Equity income themes in geographies such as Russia could actually be more interesting. Previously beaten-down geographies such as Russia and Eastern Europe offer very high dividend yields because the equity markets are heavily weighted in energy and financials, which are known to be strong dividend-paying sectors.

Investors will probably also feel compelled to actually take advantage of the correction in the sharp rises in China. Its fundamentals have weakened, but the share prices have crashed disproportionately to weakened fundamentals. That basically makes it a strong yield proposition. I think equity income themes in China could actually grow in attraction for investors.

Brazil I am very unsure about, because I think the slowdown there is also quite pronounced. But as a competing asset class, you have the bond markets to fall back to. Latin America fixed income is the asset class within emerging markets that's probably going to shine given what is unfolding right now. In China, there isn't really any income market yet, so if you want to play yield, you do it through the equities. The bond market is still in its infancy there.

I think India should be seen as a geography that has always been focused around export and growth. There are no big dividend-paying stocks there. So again, allocating defensively in this environment within emerging markets means that you probably want to play this theme around Indian bonds, similar to Brazilian bonds.

ETF Report UK: Are commodities important to watch when you're investing in emerging markets?

Nossek: Commodities are important for various reasons. Copper has been the biggest indicator for economic activity globally and in developing nations more so than in developed markets. In developed markets most of the value-add really comes from services and no longer from goods-producing industries. But in developing economies, the goods-producing industries still provide significant value-add because there's so much infrastructure that needs to be laid out, buildings that need to be built. If copper is doing well, it is a good indicator of how the economic activity in emerging markets is picking up.

The fact that copper has come down, and that the Chinese economy has been slowing down for probably four years now, means that more weakness is likely to follow. You need to understand the level of commodity prices in order to make assumptions about economic growth in many of the emerging market economies. With debasement in commodities across the board—not just copper, but also crude oil and many of the soft commodities—the deceleration of growth everywhere is likely to continue.

ETF Report UK: What are emerging market yields like after the recent sharp correction?

Nossek: In the bond market, the yields are averaging 6 and 8%, depending on which geography. The 10-year or longer government bond yields of local currency denominated bonds in India and Indonesia and Brazil and Russia are 6%, and I think that is probably an asset class investors would want to consider.

Within equities, the yields there are much higher than yields you get in the United States. The dividend yield on the S&P 500 is just shy of 2%. The 10-year US Treasurys aren't even 2%. But if you look at the yields in emerging markets, they're anywhere between 4.5-6%. This is a great yield proposition to consider.

I think overall, those emerging market economies that don't have developed bond markets as of yet will probably see investor interest in equity income funds or ETFs that offer yields around 5-6%, say, China or Russia, which has an even higher yield. But those markets that have bonds on offer can yield 6, 7 or 8%.

ETF Report UK: What role do emerging market equity income ETFs play in a portfolio?

Nossek: They offer the client exposure to defensive sectors such as energy, financials, consumer staples and utilities. Generally the more politically sensitive sectors are operating in regulated market environments, where they can afford to offer to pay a dividend or a competitive dividend.

Equities in emerging markets have become less of a growth proposition now and more of a yield proposition. If you have an equity income product that covers a wide range of emerging market countries and also offers decent dividend yields, then you have a diversified portfolio that not only offers you yield, but probably also low volatility relative to the broader equity markets.

ETF Report UK: How can emerging market small caps fit into a portfolio?

Nossek: Emerging market small caps are a very large universe in emerging markets. They essentially comprise thousands of stocks with market capitalizations of $2 billion or less. China and India comprise by and large the bulk of this universe.

Emerging markets small caps are more of a longer-term strategic investment proposition. You would want to buy into the most liquid segment of the small cap universe in order to really create an efficient portfolio.

You probably also want to focus on yield within small caps. And one way to do that is to filter from the small cap stocks universe those stocks that actually also pay a dividend. Once you have a dividend policy in place, that's basically set for the whole life of the company.