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Invesco’s Justin Leverenz – Putting emerging markets challenges into perspective

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  • EM opportunities- We believe many emerging market companies are embarking on a new era — cutting back on oversized ambitions and focusing on opportunities that are profitable and cash generative.
  • Uncertain risks- In our view, investors tend to overestimate the risks that they can see, but we believe the greatest risks are the uncertain risks that are not well acknowledged.
  • Commodity prices- As long as the world is committed to a decarbonisation agenda, this raises the prospect of potentially structurally higher resource prices.

Emerging market equities have had a challenging year-to-date performance, tracking closely disappointing returns of developed markets and US equities this year.

But looking at the longer term, the Invesco Developing Markets team believes many emerging market companies are embarking on a new era — cutting back on oversized ambitions and focusing on opportunities that are profitable and cash generative. We expect to see watershed changes in terms of earnings and returns in these businesses as they become more rational and disciplined.

Of course, we’re also facing a very difficult economic environment across the globe, with growing risks of recession. We’re closely looking at what companies we would like to own and determining where we believe the price is fair, being mindful of a potential retreat in stock prices as the world faces immediate challenges.

With all this in mind, we would like to address some frequently asked questions we are getting from investors about emerging market opportunities and risks today.

What are the positives you see in emerging markets?

From a relative perspective, we are encouraged by three important areas:

Valuations:

Broadly speaking, after a really difficult decade, emerging market equities are very cheap relative to US equities, whether we are looking at earnings, cash flow or book value.

Central banks:

Most emerging market central banks have already acted to defend their currencies by raising interest rates to deal with inflationary pressures. Rates have increased dramatically in Brazil, Mexico, Eastern Europe, South Africa, and all across the developing world.

While the Federal Reserve, the European Central Bank and the Bank of Japan have talked about trying to restrain inflation and deal with overheated economies, the developing world has already worked through that pain. In fact, emerging markets central banks are not just ahead of the curve, but actually we expect them to be in a position to reduce rates, which should have a major impact across these economies.

China:

Critically, we believe China is at a nadir in its economic cycle. China’s zero-COVID policy has had a hugely debilitating impact and its economy is incredibly weak right now. But we think over the next year or so, we will see a role reversal in the two largest economies in the world. The US is clearly overheating and the policy response to that is expected to have an adverse effect from a monetary and fiscal perspective.

We are likely going to see the exact opposite in China. It is already selectively easing in terms of fiscal, credit, property, reserve rate requirements, and other monetary policies. We believe that 12 months from now, China will be in economic recovery mode and that should lead to improvements in corporate earnings — all against a background of cheap asset prices.

There’s a lot of concern from investors right now — how would you put today’s risks into perspective?

We live in a world of enormous anxieties — geopolitics, inflation, the potential for a global recession. In our view, investors tend to overestimate the risks that they can see, but we believe the greatest risks are the uncertain risks that are not well acknowledged.

For example, many investors are worried about the negative impact that China’s zero-COVID policy and technology regulations are having on economic growth. We have visible evidence that China’s growth struggles are reducing demand for 5G smartphones.

In response, investors have sold off semiconductor design companies to the point where we believe the stocks of good companies are relatively cheap. But we don’t believe investors have connected the dots to other areas.

Just as consumers hoarded toilet paper at the beginning of the pandemic, automobile companies and other manufacturers have hoarded semiconductors by over-ordering supply. That can have an impact on foundries and the capital equipment behind the foundry.

What we have been doing over the last couple of months involved finding and investing in opportunities where the visible risks are well understood, have been deeply digested, and have led to discounts in prices — and looking out for circumstances where the risks have not yet been widely perceived. 

What’s your view of commodities and the recent volatility in the asset class?

Commodities by definition are always volatile, because prices are determined by the intersection between excess supply and demand. That said, we believe that as long as the world is committed to a decarbonisation agenda, “The Great Energy Transition” as it’s called, this raises the prospect of potentially structurally higher resource prices. That is for two key reasons:

  • Hydrocarbon companies, broadly speaking, have little incentive for greenfield expansion in an environment where they know 20 or 30 years from now, the demand environment is going to be entirely different, shaped by ESG considerations. A lack of investment would, over time, contribute to a higher hydrocarbon price environment.
  • More importantly, decarbonisation on a large scale would require enormous investment capital to expand solar and wind farms, transition toward electric vehicles and adapt the power grid accordingly. In addition to being incredibly capital intensive, these projects would be very mineral intensive for resources like nickel, copper and cobalt. And these resources are largely located in geographies that come with challenges for producers. For example, Chile represents 30%2 of the world’s copper production, and the country just elected a leader who’s advocated for significant increases in the royalty rates and taxation of the mining industry, which we expect would make it almost impossible for the industry to want to commit more capital to mining projects there. Central Africa also has unique challenges associated with political turmoil.

The massive increase in commodity prices we have seen over the last couple of months has little to do with these longer-term structural issues. Rather it has more to do with the challenges associated with replacing Russian imports with resources from different geographies and Russia finding the ability to reposition its resources into other markets.

But broadly speaking, we believe resources, hard commodities and energy structurally are going to be influenced by these structural forces.

That being said, we spend a lot of time looking at companies and determining what price we would want to pay for them. It is our view that in the next six to 12 months, there is a strong probability that the world could move into a significant recession.

We are looking at what we want to own and determining where we believe the price is fair, while being mindful of a potential retreat in stock prices because the world is looking challenging in the short term.

What are some of the areas that you’re most excited about for the future?

We have been in a very volatile climate for the last couple of years. Long-duration assets were everything in 2020 — by that we mean either young, less mature companies or growth-oriented companies.

But with a few rare exceptions, these types of companies have sold off dramatically across the developing world over the past year. Within that indiscriminate sell off, there are clearly companies that, in our view, represent great opportunities over the next three, four, five years.

In the developing world, we think we are now in the environment where boards, entrepreneurs, and shareholders have shifted the focus.

Instead of preparing PowerPoint presentations showing off enormously ambitious market opportunities that require significant investments and involve great uncertainty about the profitability of those opportunities — we find that companies are increasingly restraining their ambitions and focusing on opportunities that are profitable and cash generative.

As they peel back the investments and focus on the core and profitable near-term opportunities, we expect to see watershed changes in terms of the earnings and returns in these businesses as they become more rational and disciplined.

We think the most advanced emerging market in this regard is China. And looking ahead to a post-zero COVID China, where the economy goes back to potential growth of 4% or 5%, we expect these companies to strike the interest of investors again.

We also anticipate in a year to 18 months later, we’ll see the same sort of behaviour beginning to emerge in company boards in places like Brazil and Indonesia. There’s been recognition that profitable opportunities may be very different than the aspirational ones, where there’s competitive landscape needs to consolidate in order to reach profitability in nascent industries like e-commerce, FinTech and other parts of the new economy.

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