This interview is based on a teleconference call with David Lazenby, head of emerging markets at Batterymarch Financial Management, and Ray Prasad, senior portfolio manager in the firm’s emerging markets team. Batterymarch manages the Legg Mason Batterymarch Emerging Markets Equity Fund and the Legg Mason Batterymarch Asia-Pacific Equity Fund.
Can you outline the recent performance of emerging markets?
Lazenby: Over the past decade there have been corrections in the upward performance of emerging markets, although all of them occurred during periods of global market weakness. The recent performance of the asset class was an exception as the relative underperformance of emerging markets that began in mid-October last year – amounting to about -12% relative to developed markets since then – occurred within an environment of rising global markets. In absolute terms, emerging markets have not really experienced a correction, as they actually traded sideways from mid- October until mid-February.
How have individual country markets performed?
Lazenby: There has been notable underperformance in recent quarters of segments of the emerging markets universe leveraged to domestic demand relative to those leveraged to global growth and demand. Countries leveraged to global growth such as Taiwan, South Korea and Mexico underperformed during the first three quarters of 2010, continuing a trend apparent since the beginning of the recovery from the global financial crisis because emerging markets growth was stronger. So emerging-market-leveraged countries outperformed, while those more leveraged to developed demand underperformed. In the rotation of the past two quarters the reverse happened. Markets such as South Korea and Taiwan performed well, while those leveraged to domestic demand, such as Indonesia, Turkey and smaller Latin American countries, underperformed. While investors began to anticipate that growth in developed markets may be better-than-expected, inflation fears began to increase with regards to emerging markets. Markets were no longer viewing deflation as the primary fear for developed markets, while emerging markets were perceived to be potentially overheating. Inflation was picking up and central banks were beginning to tighten, particularly in China. So in emerging markets there were concerns about overheating and inflation, while the developed economies were still pump-priming.
Do you expect further monetary tightening in emerging markets?
Lazenby: We think there will be more tightening in emerging economies but the most aggressive part is over, whereas it’s only beginning in the developed world. We think developed markets are now beginning to discount the cyclical trend that has largely been discounted by emerging markets. But we are concerned about the potential for continued high energy prices.
How has this influenced your portfolio positioning?
Lazenby: In our global emerging market strategies we tend to be a little overweight in Russia, as well as Brazil and Mexico, and a little underweight the Asian markets broadly. This is partly because of energy but, more importantly, because Latin America and Emea are generally more leveraged to domestic demand and the big Asian economies, while they have the domestic story, are highly connected to global growth. We believe emerging markets continue to be the story with strong fundamentals. We think the cyclical rotation has largely passed and want exposure to domestic demand in emerging markets. That’s how we are positioned. We’ve moderated exposure so that we are not as overweight in Latin America and Emea, nor as underweight in Asia. Our general positioning, however, is to be overweight to domestic demand plays.
What notable changes have you made to individual country exposures?
Lazenby: The biggest single move at the macro level is that we have moderated our stance in South Korea. It is now a small overweight in both our global emerging markets and our Asia ex-Japan strategies, as is China. Both countries are relatively larger overweight exposures in our Asia-only strategies. Six months ago, Korea was among our largest underweight positions. We are seeing benefits from both domestic demand in Korea and leverage to stronger global growth than anticipated six months ago. Korean companies, such as auto stocks, where we’ve always been overweight, continue to do well. As primary competitors to the Japanese auto sector, they have benefited from the tragic events in Japan. Elsewhere, we have moderated our exposure in energy, where we had been underweight for some time. Now we have a more neutral-to-slight-overweight position. We recognise that some global growth drivers have strength and the cyclical opportunity there is stronger than it was, but we believe is still tilted, in general, to domestic demand.
Can you elaborate on your thoughts about inflation in Asian countries?
Lazenby: We haven’t returned to the inflation levels of 2008 and don’t believe we will. In China, the consensus is for inflation peaking at 5.5% to 6% and, by early summer, inflation beginning to trend to 4%. Potentially, China could still hike rates once or twice more.
Prasad: Much of the present inflationary pressure relates to food prices, which will probably start easing in the middle-to-third quarter of 2011. There’s some concern over energy prices and, as they are generally energy importers, Asian countries’ inflation rates and fiscal balances are impacted significantly by oil prices. Typically, investors thought central banks were behind the curve, but now see that this is not so. They are proactive, looking ahead and realising that a lot of inflation was non-core and so were not trying aggressively to curtail it through rate rises.
There was a correction of
almost 20% in India. Do you see that market rebounding?
Prasad: India is most affected by the net energy impact on emerging economies that we mentioned earlier. The oil price rise creates problems for the government’s fiscal balances, crowding out growth or credit that would boost the economy. So energy was a big factor in India’s correction. The second driver was rising food prices. India has always been highly valued relative to Asia and emerging markets. In 2010 we saw record inflows and India did fairly well. Then money flowed out and there was a sharp correction. Longer term, we don’t think it’s a structural problem and when oil prices fall, the Indian market should respond positively. Valuations had declined to around 14-to-15 times earnings, which we feel is a good level to buy.
Low-cost production is shifting from China to markets such as Vietnam. Do you see opportunities there?
Prasad: Vietnam has regulations that make investment difficult. We have some exposure but more to the commodity and real estate areas. It’s true that some industries have left China because of costs, for example, textile manufacturers have relocated to Bangladesh, Vietnam and Cambodia. But they’re difficult to play because they may not be listed, or are small or illiquid. Other companies like Hon Hai, a Taiwanese company with exposure to China, had most of its factories on the east coast of China and has moved to the very competitive western parts of the country where – with a 30% to 40% wage-cost differential – it will benefit from lower costs and wages.
What are your expectations for
emerging markets over the rest of 2011?
Prasad: We believe emerging markets should resume their outperformance because the structural story is unaltered. On liquidity, China is among those countries to have tightened but we’ve seen some easing, and looking at inflation we are seeing some softening. We also see inflows returning to emerging markets. We believe valuations are attractive, with earnings multiples in the low teens and reasonably solid growth. A key question is where the next margin improvement for companies in emerging markets will come from. If improvement does not materialise, we could see a trading range for emerging market equities, but if the market realises that company margins over the next few quarters are sustainable, we believe stock prices should start rebounding gradually and consistently. We think there will probably not be a huge uptick, but more a steady improvement for the rest of 2011 on an absolute and relative basis.