Inflation wonÆt derail the Bric story
Equities in large emerging markets remain attractive, with global volatility having served to return valuations to neutral, says RCM.
Michael Konstantinov is RCMÆs fund manager for global emerging markets, Bric markets and Eastern European portfolios. Based in Frankfurt, his team manages a total of Ç3 billion ($4.6 billion), with roughly a third dedicated to each type of portfolio.
AsianInvetor: Will emerging stockmarkets continue to lose value this year?
Michael Konstantinov: Emerging-market equities are subject to developments in global markets. They will remain high-beta markets but to what extent? So far we are nine months into the US financial sectorÆs troubles and thereÆs been only limited impact on economic growth in emerging countries. Downward revisions for global emerging markets have been slight. So weÆre waiting to see if there will be more downgrades of these economies û but the consensus view is to expect growth.
WhatÆs RCMÆs most likely scenario?
We see by mid-2008 investors come to realize economies in emerging markets, particularly the main Bric [Brazil, Russia, India, China] countries, are only partly affected by the US slowdown. Their growth is not driven just by exports, but within their own economies. Infrastructure investment, for example, is less cyclical; the need for infrastructure development is clear wherever you go, and the financing is there.
Also, consumers in these countries had to hold back for years but in the past two years they have begun to spend, thanks in part to real wage growth, and also to access to financing. In Russia and Brazil, for example, real interest rates have come down. Consumption can be leveraged, debt levels are quite low, and consumer sentiment is positive.
In Bric economies, what is domestic investor sentiment like?
ItÆs positive, again because balance sheet debts have been reduced and companies are enjoying high levels of cash flows. They have reached their capacity limits and have to invest. Out of the five main drivers weÆd look at, four are still positive, with only exports showing difficulties.
Frontier markets, the next generation of emerging-market stories, have been in vogue. How do you rate these markets versus Brics?
Some frontier markets are not really investable. Nigeria, for example, is talked about as part of Goldman SachsÆ ôNext 11ö countries. These places have potential but their markets arenÆt accessible. Vietnam has high rates of growth but itÆs at the early stages of developing its capital markets. ThereÆs a lot of money chasing the same names there. Places such as Vietnam are interesting but only if the price is right.
Brics, on the other hand, combine sustainable, high rates of growth with broad-based economies. They have large capital markets, which allow companies there to leverage and grow. The future Wal-Marts and Starbucks will come from big emerging markets, and we want to find and invest in these at the early stage of their development. Over time Bric markets will make up a significant portion of global indices.
Valuations in Bric markets have been high.
TheyÆve come down in the current market correction. And as the performance numbers switch from 2007 to 2008 figures, and as people focus on more earnings expectations for 2009, they will look attractive. Brics trade in line with global emerging markets û Brazil and Russia are a little cheaper, at 10-11x expected p/e for 2008, China and India a little more expensive, at around 15-17x 2008 earnings. And so far earnings have held up. In 2007, Bric stocks experienced 20-30% earnings growth on average, and for 2008 we expect around 22%. Even if that gets revised downward, weÆre looking at 15-20%, which is still attractive.
Has your Brics portfolio rotated in terms of sector, market weighting or style?
No, itÆs the same themes: infrastructure, domestic demand and to some extent commodities. Domestic demand can take the form of banks, retail or pure consumption-related producers, depending on the country.
What about inflation?
We monitor how governments react to inflation. Although itÆs high, it hasnÆt broadened beyond energy and food prices. We should see it level off and eventually decline. Inflation growth in 2008 year on year is less than in 2007, so far.
You say itÆs just food and energy but that is a lot.
Food items like pork have seen sharp price increases in places like China because of diseases, but later this year I expect food inflation to subside. Central banks are using currencies to counter inflation pressures: last year it was India, which let the rupee appreciate after it had to raise interest rates. Today the Reserve Bank of India is one of the few central banks that doesnÆt need to raise interest rates. It can even cut rates once inflation subsides. Other emerging markets such as Thailand and Taiwan seem to be following this approach.
You manage a portfolio of global emerging markets. What do you do if index vendors upgrade Taiwan and Korea?
From a GDP perspective these already qualify as developed markets, but they have political issues û North Korea, Taiwan strait tensions û so I doubt weÆll see a quick change in their index status. If indices did change, however, we would have to reflect that change in our portfolios.
Among Bric countries how are you re-weighting the portfolio?
We currently favour Brazil and Russia. We were heavily underweight China but weÆve recently closed that gap in the past few weeks. H shares have declined by 40% from their October peak and look attractive again. We have a small underweight position toward India. At some point weÆll need to reduce our overweights to Russia and Brazil.
AsianInvetor: Will emerging stockmarkets continue to lose value this year?
Michael Konstantinov: Emerging-market equities are subject to developments in global markets. They will remain high-beta markets but to what extent? So far we are nine months into the US financial sectorÆs troubles and thereÆs been only limited impact on economic growth in emerging countries. Downward revisions for global emerging markets have been slight. So weÆre waiting to see if there will be more downgrades of these economies û but the consensus view is to expect growth.
WhatÆs RCMÆs most likely scenario?
We see by mid-2008 investors come to realize economies in emerging markets, particularly the main Bric [Brazil, Russia, India, China] countries, are only partly affected by the US slowdown. Their growth is not driven just by exports, but within their own economies. Infrastructure investment, for example, is less cyclical; the need for infrastructure development is clear wherever you go, and the financing is there.
Also, consumers in these countries had to hold back for years but in the past two years they have begun to spend, thanks in part to real wage growth, and also to access to financing. In Russia and Brazil, for example, real interest rates have come down. Consumption can be leveraged, debt levels are quite low, and consumer sentiment is positive.
In Bric economies, what is domestic investor sentiment like?
ItÆs positive, again because balance sheet debts have been reduced and companies are enjoying high levels of cash flows. They have reached their capacity limits and have to invest. Out of the five main drivers weÆd look at, four are still positive, with only exports showing difficulties.
Frontier markets, the next generation of emerging-market stories, have been in vogue. How do you rate these markets versus Brics?
Some frontier markets are not really investable. Nigeria, for example, is talked about as part of Goldman SachsÆ ôNext 11ö countries. These places have potential but their markets arenÆt accessible. Vietnam has high rates of growth but itÆs at the early stages of developing its capital markets. ThereÆs a lot of money chasing the same names there. Places such as Vietnam are interesting but only if the price is right.
Brics, on the other hand, combine sustainable, high rates of growth with broad-based economies. They have large capital markets, which allow companies there to leverage and grow. The future Wal-Marts and Starbucks will come from big emerging markets, and we want to find and invest in these at the early stage of their development. Over time Bric markets will make up a significant portion of global indices.
Valuations in Bric markets have been high.
TheyÆve come down in the current market correction. And as the performance numbers switch from 2007 to 2008 figures, and as people focus on more earnings expectations for 2009, they will look attractive. Brics trade in line with global emerging markets û Brazil and Russia are a little cheaper, at 10-11x expected p/e for 2008, China and India a little more expensive, at around 15-17x 2008 earnings. And so far earnings have held up. In 2007, Bric stocks experienced 20-30% earnings growth on average, and for 2008 we expect around 22%. Even if that gets revised downward, weÆre looking at 15-20%, which is still attractive.
Has your Brics portfolio rotated in terms of sector, market weighting or style?
No, itÆs the same themes: infrastructure, domestic demand and to some extent commodities. Domestic demand can take the form of banks, retail or pure consumption-related producers, depending on the country.
What about inflation?
We monitor how governments react to inflation. Although itÆs high, it hasnÆt broadened beyond energy and food prices. We should see it level off and eventually decline. Inflation growth in 2008 year on year is less than in 2007, so far.
You say itÆs just food and energy but that is a lot.
Food items like pork have seen sharp price increases in places like China because of diseases, but later this year I expect food inflation to subside. Central banks are using currencies to counter inflation pressures: last year it was India, which let the rupee appreciate after it had to raise interest rates. Today the Reserve Bank of India is one of the few central banks that doesnÆt need to raise interest rates. It can even cut rates once inflation subsides. Other emerging markets such as Thailand and Taiwan seem to be following this approach.
You manage a portfolio of global emerging markets. What do you do if index vendors upgrade Taiwan and Korea?
From a GDP perspective these already qualify as developed markets, but they have political issues û North Korea, Taiwan strait tensions û so I doubt weÆll see a quick change in their index status. If indices did change, however, we would have to reflect that change in our portfolios.
Among Bric countries how are you re-weighting the portfolio?
We currently favour Brazil and Russia. We were heavily underweight China but weÆve recently closed that gap in the past few weeks. H shares have declined by 40% from their October peak and look attractive again. We have a small underweight position toward India. At some point weÆll need to reduce our overweights to Russia and Brazil.
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