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Investors should increasingly look towards emerging markets for income as conditions in developed markets remain challenging, argues Nick Samouilhan.
Little has changed for income-seeking investors over the past few months, with relatively little reward available in markets that have traditionally provided steady sources of income. Dividend yields remain low, with the gross redemption yield on the FTSE All World Index unchanged at 2.4 per cent over the three months to the end of June1. Meanwhile, bond yields offer little relief. The Federal Reserve hiked interest rates in June, the third successive quarterly increase by the US central bank, with the likelihood of more to follow. Yet the yield on 10-year treasuries fell to 2.28 per cent at the end of June from 2.41 per cent at the end of March and gilt and bund yields remain at very low levels2&3.
Meanwhile, spreads on investment grade and high yield bonds continue to decline. Central bank stimulus in Europe and Japan has driven the fall, with income-hungry investors moving into riskier parts of the markets as they chase yield.
So just where can income seekers find opportunities given this backdrop? Emerging market equities could be one option for investors. The asset class gained just under 12 per cent on a total return basis in US dollars in 2016, but this has proven only the warm up for 2017, where by the end of May they were up 17 per cent on a comparable basis 4.
Despite earnings growth for EM corporates outstripping their developed market counterparts, since 2014 emerging market equities have consistently traded at an approximate 30 per cent discount to developed markets. Earnings expectations continue to remain supportive for emerging markets5.
They also benefit from a number of tailwinds, including a weaker-than-expected dollar, which has allayed fears that monetary policy tightening by the Federal Reserve would pressure the dollar-denominated debt of emerging economies; and receding fears President Trump will pursue aggressively protectionist measures.
The improving global economic outlook is also driving corporate earnings’ expectations across emerging markets. Countries such as Brazil and Russia, both of which experienced significant recessions over the past two years, are both now pointing towards economic expansion. The importance of China and the strength of its economy cannot be underestimated for emerging markets, and here too the news is encouraging. We believe it is possible that China could grow faster than the 6.5 per cent to seven per cent target range this year. External demand, particularly from within Asia, is proving stronger than expected, while the economy is also benefiting from robust domestic demand.
As well as a enjoying a relatively healthy income, investors in emerging market equities are better placed to benefit from capital growth. That is because the highest income-generating stocks in developed markets tend to be focused on defensive sectors such as utilities, while there is a greater focus on growth dividend stocks in the emerging world.
Favoured markets in this area include South Africa and Turkey, despite political and economic challenges. South Africa has fallen into recession, its credit rating has been downgraded, there are concerns about the central bank’s continued independence and President Zuma, whose term expires in 2019, is facing mounting calls to step down early6. Meanwhile, Turkey’s credit rating has been downgraded to “junk” status by all the major credit ratings this year7. The political situation remains tense following last July’s failed coup, while there are concerns over the long-term economic outlook8. However, equities in those markets have sold off sharply and the risk reward profile appears attractive over the short to medium term.
Turkish government bond yields also offer opportunities. The central bank tightened interest rates last year to contain inflation, but they seem unlikely to rise higher given concerns about the outlook for economic growth. Ten-year Turkish sovereign bonds, denominated in dollars, currently yield over five per cent, providing an attractive spread over US treasuries9.
Indonesia is another preferred issuer. It is now one of the faster growing emerging markets, expanding over five per cent in the first quarter of 201710. The pace of growth is less rapid than in India (7.5 per cent over the same period)11, but significantly faster than Brazil (estimated at 0.7 to 0.8 per cent)12. The government has begun an ambitious reform agenda, aiming to widen the tax take, accelerate investment in Indonesian infrastructure, cut energy subsidies and reduce bureaucracy.
We also favour various investment strategies that can generate capital growth from which we can pay an income. For example, we favour the India rupee. The currency should benefit from the strongly-performing economy, which is expected to grow by 7.3 per cent in the 2017/18 fiscal year 13. Concerns about the Reserve Bank of India’s independence, which arose over the central bank’s role in the recall of 86 per cent of the country’s currency last November, have also faded. In June, the bank ignored pressure from the government to ease monetary policy, keeping rates unchanged at 6.25 per cent14.
The government is also driving though some impressive and politically challenging reforms, the demonetisation of the economy being a case in point. That move hurt the economy in the short-term but, by eradicating swathes of the black economy, should drive tax revenues higher over the longer term. The introduction of a new goods and services tax on 1 July should cut red tape and increase tax revenues, fuelling economic growth in the long term by removing domestic barriers to trade, which should support productivity gains, according to the ratings agency Fitch15.
India’s self sufficiency should also support the currency. In an uncertain world, India is well placed to withstand geopolitical instability such as greater protectionism or a downturn in the global economy. Exports accounted for less than 13 per cent of GDP and external debt stood at just 23.4 per cent of GDP at the end of fiscal year 2015/1616.
While the picture for developed markets is more complicated, opportunities still exist for the discerning investor. We currently favour European equities both for their income and capital growth potential. Political concerns have weighed on the region in the past year, but these appear to be lifting. Not only are European equities attractively valued, but earnings momentum is stronger than in the US where there are signs that margins are getting squeezed, with rising wage costs starting to have an impact.
The relatively weak demand environment combined with deflationary pressures has meant European corporates have faced a significant squeeze on their ability to push through price increases. We are seeing some signs of improvement here, with demand improving and inflation coming back into the euro-zone economy.
The increase in inflation expectations has helped provide some pricing power, which had been largely absent in the prior deflationary cycle. Industries with higher operating leverage are also benefitting from an improvement in top-line growth. Even a relatively small uplift in margins, combined with further top-line growth, would be enough to drive a meaningful acceleration in earnings.
In the last three months there have been significant upgrades for European companies, with only Japan seeing more upgrades relative to downgrades in terms of developed regions. In fact, earnings per share growth expectations for 2017 in Europe have been rising steadily for the past eight months and currently standing at 18.9 per cent17.
This is a marked contrast to the previous five years, where we have seen cumulative downgrades in the region of 10 per cent every year. Leading indicators would also suggest that this momentum is sustainable, with a relatively strong historic relationship between business surveys such as the ISM and PMIs and earnings per share (EPS) growth. The recent bounce we have seen in both survey indicators should bode well in terms of achieving the elevated consensus expectations.
In fixed income we also see opportunities in Australian and Canadian government bonds. Canadian 10-year bonds offer a spread of 57 basis points above US treasuries and 129 basis points over bunds, while the Australian counterparts offers spreads of 226 basis points and 40 basis points respectively18. Both economies, particularly Canada, face economic challenges due to their reliance on commodity markets. This makes it unlikely that interest rates will increase in the foreseeable future, even though housing markets are flashing red in both cases.
1 Financial Times Market Data, 1 July 2017
2 Financial Times Market Data, 1 July 2017
3 Financial Times Market Data, 1 July 2017
4 Aviva Investors’ House View Q2 2017
5 Aviva Investors’ House View Q2 2017
6 Reuters 20 June 2017: South Africa adds central bank row to economic and political troubles
7 Financial Times 27 January 2017: Turkey cut to junk by Fitch, losing last major investment-grade rating
8 Bloomberg 22 June 2017: Why Erdogan Is Flooding Turkey’s Economy With Credit
9 Bloomberg, USD Turkey Government Bond Generic Bid Yield 10 Year, 27 June 2017
10 Source: Bloomberg, as at 31 March 2017
11 Source: Bloomberg, as at 3 April 2017
12 Source: Thomson Reuters, as at 4 April 2017
13 Reserve Bank of India Financial Stability Report 2017-18, June 2017
14 Bloomberg 12 June 2017India Central Bank's Freedom Gets Crucial Test
15 A Fitch: India GST Bill a Positive Reform Signal, 4 August 2016
16 IMF Staff Report on India, January 2017
17 Aviva Investors’ House View Q2 2017
18 Financial Times Market Data, 1 July 2017
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