Twenty years ago, on the 30th of June 1997 the sovereignty of Hong Kong was reversed to China. Two days later, the devaluation of the Thai baht marked the start of the Asian crisis.
At the time emerging markets (EM) assets had already underperformed developing markets (DM) assets for a number of years and the Asian crisis extended this. Only by the end of 1998 did EM assets start to bottom out and another three years had to pass before the rebound in Asian economies, the end of the U.S. recession in November 2001 and China joining the WTO in December 2001 created the environment for renewed outperformance. Almost a decade of spectacular outperformance followed as China was integrated into global trade, delivered high growth and the associated commodity demand led to large gains in commodity prices benefitting EM producers.
These episodes are examples of the prolonged periods of EM out and underperformance relative to DM which have been a key characteristic of EM assets for the last 30 years.
With EM equities having underperformed again since 2010 as growth in China moderated, commodity prices collapsed and these impacts were exacerbated by existing imbalances in a number of EM economies, the 20 year anniversary for Hong Kong’s transfer to China comes at a time, when investors need to decide whether the bounce we have seen in EM assets since January last year is a temporary blip or the start of another prolonged period of outperformance.
In the Global Portfolio Solutions group at Goldman Sachs Asset Management, we strongly believe in the latter. We think that valuations have become attractive, and that enough progress has been made on the headwinds to growth, that EM growth can start to rebound. Such rebounds in growth have historically been associated with EM equity outperformance.
On the valuation front, EM currencies are now about as undervalued as they were in the early 2000’s before the last large bull market in EM assets. This matters as currency losses were a big driver of the last bear market. EM equities are also attractively valued relative to DM equities, with the relative ratio between price and earnings being at the 37th percentile of its historical distribution. Finally, if EM economic growth rebounds, we would also expect a rebound in earnings.
On the growth front, we believe that the decline in commodity prices is now behind us. We expect more range bound commodity markets from here, in line with the experience over the last couple of years. We think that growth in China can still slow a bit. This will be a headwind to EM growth in general, but it will be much milder than the rapid decline in Chinese growth we have seen since 2007. Finally, the imbalances, such as large current account deficits in some EM countries have improved significantly.
The headwinds to growth in recent years have brought EM growth outside of China substantially below our estimates of what can be sustained over the longer term, given population growth, investment and technological progress. With the headwinds fading we believe we are currently in the early stages of EM growth outside of China increasing towards its longer term potential, bringing EM equities along for the ride.
The main risk to our view would be a hard landing in China. We agree that the current pace of credit creation in China is unlikely to be sustainable over the long term. But for at least the next few years we think the government has both the will and the recourses to avoid a hard landing, and as such we are willing to own this risk.