Emerging Markets: Time to Check Expectations

Stipp: The first question for you, based on the Morningstar's fund flows, emerging markets as well as some more conservative asset classes have been particularly popular with investors, and certainly the emerging markets have had topnotch performance over several trailing time periods. In your perception, is the emerging-markets area becoming overheated based on all the attention that it's had recently from investors and its recent performance?

Foster: I am so glad you brought that question forward and precipitated the issue. I think it is time for investors to at least cool down or possibly even reset their expectations for the performance of this category in the coming years, at least when I look at these emerging markets from an Asian context. I am not particularly an expert over Latin America or Eastern Europe.

The reasons I say this: I've just returned from several visits in the region itself doing the sort of research we do in the field there, and I think growth is undoubtedly strong in many of the markets at an economic level, and I think we're quite encouraged as to what we see unfolding over the next few years.

That said, we have seen valuations be pushed steadily upwards for quite some time now. In my opinion, a lot of the performance we've seen in recent months has more to do with the influx of liquidity in the markets in Asia, partly driven by some of the quantitative easing going on in developed markets around the world and other factors, especially many of the markets in Asia themselves are quite replete with savings and liquidity.

And consequently, we've seen valuations push steadily upward, and they are beginning to disconnect a bit I think from the pace of fundamental growth in these markets. That always worries me when we have valuations separating from the underlying fundamentals and macroeconomic conditions.

I would highlight this especially just on China, because I think it's very clear to me, again, at least that the economy there is going to be on a decelerating trend over the next few years. We are not talking about growth falling off a cliff, but the authorities in that country are working very aggressively to restructure and reposition the economy, and I imagine that will mean a deceleration in headline growth rates from the sort of 9% to 10% rates of growth that people have grown accustomed to, to something probably between 6% and 8% in the next few years.

I am just not certain that investors are really aware of this issue or are focusing on it, and I think it's very important that they do so.

The last thing I would say on this: Perhaps the most crowded trade of all at the moment is the short dollar trade. There is a huge amount of capital pushing into Asian currencies and Asian currency-denominated securities such as stocks and bonds. There is somewhat of a flight from perceived weakness in the dollar, and I can understand certainly why people wish to make this trade, but it's become very crowded. I think it maybe overestimating some of the underlying strength in the Asian currencies at least in the short run.

Stipp: Andrew, in your answer there you'd mentioned the fundamentals and then also where some of the valuations are. Now, you folks are obviously paying close attention to the fundamentals of the companies you invest in. Given the situation that you've outlined, what does that mean for how you've been managing your portfolio, and have you been able to uncover any opportunities even if the market overall has been looking perhaps a little overheated?

Foster: We do work on a bottom-up individual company basis, so we continue to find attractive investment opportunities, but the market overall is becoming more difficult or problematic in that regard.

I think where I am focused, and many of us at Matthews here are focused, is increasingly on some of the telco industries. They have not been particularly attractive for growth in recent years, the telecommunication stocks. There has been too much capacity, too much price competition on wireless and fixed-line telecommunication services, but I think the valuations on this sector are very much reflected. It's one of the cheapest sectors in Asia today, both on price-to-earnings basis, price-to-books basis and also especially on a dividend yield basis.

What I see happening at the margins is a little bit of growth recovering in this industry. It's been pushed by all the things that we understand here in the States, the demand for especially wireless mobile data, for smartphones and tablet computers and wireless PCs and whatnot, and this is driving more demand and some of these companies are going from a very mature state or at least the perceived mature state to a slightly higher rate of growth, I think, over the next few years, and that's very encouraging to me.

I would also highlight that we are looking a lot at service-driven business models; a lot of investors are looking to play off of commodities or material themes in the region, and those sectors look fairly expensive to me at this juncture. I also think a lot of the consumer-oriented industries, which have been our historic stomping ground, are very, very heavily valued at this juncture, unfortunately.

But we are quite keen to focus on some of the emerging and new service-driven business models, whether they are consumer services or industrial and businesses services that we think have room for growth in Asia. The one thing I would caution investors on that front, though, is that investment bankers in the region are very keen to capitalize on this demand, and they are bringing forward a lot of very heavily or very highly valued new offerings and IPOs to the market, and people need to be very wary about what they are investing into at this juncture.

Stipp: Andrew, the other side of that discussion, so we talked a bit about opportunities and valuations there. You said that you'd got back from a recent trip in answering the first question, and you were still impressed with a lot of the fundamentals, the fundamental story that you were seeing.

A lot has been written recently about the emerging markets and how, in some ways, they are actually looking stronger than some of the developed markets as far as the sovereign balance sheets and up-and-coming middle classes, and the internal demand that you might be seeing in emerging markets.

Can you compare the fundamentals of what you're seeing in some of your regions, with what we might be seeing in the developed world and what opportunities there might be for the emerging markets to continue basically to enter the developed world?

Foster: Well, I think the news from the ground is quite encouraging in that regard. It's difficult, unfortunately, here in the States: We've had such a tough time in this economy, and people are still mired in a tough economic environment. If it's not an outright recession, it's definitely a difficult environment for employment and growth.

It really is a different case in Asia today and even moving away from the fundamentals for a moment, economies really do at the end of the day run on confidence, and confidence is quite high in Asia right now, and you really do see it in the level of economic activity that's taking place in the region, the kind of underlying growth, and frankly you can even see it when you walk some of the streets in that part of the world.

Asia has gone through this recent downturn in much better shape, and it's largely because as you alluded to, the balance sheets of both companies and households and even governments have been in better shape, and balance sheets don't provide growth, but they do provide flexibility, especially during times of stress, and those balance sheets definitely gave companies and consumers time to reposition themselves when the global growth slowed down, and find new avenues for growth, and generally I think the conditions are stronger. It's really hard to see that unless you spend some time in these markets yourself. You can read about it, but it really is a distinct difference.

I do think, though, one has to be careful because we're entering a heavy investment cycle in Asia, it looks to be the case at least, and again I would suggest there is a lot of issuance – investment bankers are very keen to capitalize on the demand for investors' exposure to Asia, and they are very keen to issue a lot more of the securities, whether fixed income or equity issues or what have you. One of my concerns is that this issuance may overwhelm markets or at least swamp markets in the short run. It's healthy in the long run to have this new capital raised and be put to work, but in the short run it may put a damper on things.

Stipp: Andrew, a lot of investors look to the emerging market for diversification purposes. Yet, we see in today's world, there is a lot of interconnection globally. So you have emerging markets with a lot of their business happening in developed markets, and developed markets becoming increasingly connected to emerging markets in some ways. Do you see that correlations between the emerging and developed world may start to become a lot tighter, and do you see that the emerging markets may provide less of a diversification benefit in the future than maybe they have in the past?

Foster: I think that argument is spot on, Jason. But I would suggest that ... it has mixed pros and cons, and in the end, it's a net benefit to investors, and the reason I say this is, Asia's markets are broadening and deepening. For the most part, this means that the scale of opportunities, the stability of the opportunities, the sustainability of the growth is all improving, and instead of being a set of small relatively backward and disconnected markets that were often very volatile and to some extent inconsequential to investors portfolios, these markets are bigger, broader and healthier today.

Unfortunately, I think the downside to this is that they are more linked to the rest of the world, and I do think that means that there will be greater degrees of correlation, particularly over the short run between market performance in these markets and global markets. I think it's hard to escape that, but it's definitely of net investor benefit; rather than owning a small piece of a small market that was very volatile and inconsequential, maybe it was uncorrelated and therefore offered diversification. Now, we're talking about markets that are maturing and broadening and offer scalable and sustainable investment opportunities, albeit more correlated ones.

Stipp: Last question for you Andrew, you talked about some of the things that investors need to be cautious about in emerging markets in several of your answers. I know that one thing that investors have worried about in the past is corporate governance issues and certain surprises that may happen in emerging markets that they wouldn't necessarily have to worry about in more developed markets. Can you outline some of the key risks beyond what you've discussed that you see that investors should still have on their radars today?

Foster: I think there are several key risks that I would highlight. I mentioned earlier that the short dollar trade is a bit overcrowded at this juncture, and I am concerned that investors are taking it too tacitly that Asian currencies are poised to rise against the U.S. dollar. I think that's always a source of concern. I think that the repositioning of the Chinese growth model may take some investors by surprise at this juncture, and that's also an issue.

I think there are some worrisome signs about military conflicts or military tensions in the region escalating, and I think that is a concern as well. And I think one last key issue is that there are increasing signs that some of the liquidity influx in the region is really pushing governments in the region to contemplate the introduction of capital controls, which may inhibit the free flow of investor capital in the region.

So between these issues: very widely assumed benefits for Asian currencies in the future, the possible introduction of capital controls, and possible military tensions in the region emerging, I think these are the things that investors need to watch out for.

Stipp: Andrew Foster, Matthews Asia Funds, it's always great to hear your insights. Thanks so much for calling in today.

Foster: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.