Improving Cashflows
Cashflows are another reason why we like emerging markets. In the last decade, emerging markets have underperformed the developed world in terms of return on equity. But for the last decade there has been a trend of improving free cash flows (in both absolute terms and relative to developed markets) that has accelerated in the last year. Emerging market companies are generating much more free cash this year because both commodity-oriented and technology-oriented companies (in particular the semiconductor industry) have been doing well. As cashflows increase, we believe ultimately this will result in improved returns on equity for emerging market stocks and should likely propel a rerating.
While we do see reasons to be optimistic, we should mention the near-term risks in our outlook. Regulatory changes happening in China have ramifications for a number of industries and many internet related stocks in particular. This is impacting earnings power in the near term, and also potentially further into the future.
And of course, we are still living with COVID-19 and the more infectious variants. We had expected with rising vaccination rates, mobility would automatically resume. However, that hasn’t necessarily been the case. In Singapore, for example, the vaccination rate is now above 80%, but COVID-19 cases remain widespread, and many mobility restrictions are still in place.
We would also note that while commodity prices have been very strong this year, they seem to be topping because of China’s policy measures as well as the global resurgence of COVID that has acted to suppress demand during lockdown periods. In addition, a dramatic rise in freight rates has had a negative impact on margins for many export-oriented companies.
In sum, we believe the long-term fundamentals for emerging markets remain attractive despite near term headwinds, and that equities offer good potential for investors. While the economic recovery from COVID-19 could be more muted going forward, growth remains historically strong, valuations appear cheap, and earnings prospects are supported by rising cashflows.
