Emerging Markets to outperform big time

My view when the markets bottomed out in the month of March 2009 was that the structural issues that the Western economies are facing along with the huge leverage on the balance sheets of various financial institutions will imply below par economic growth combined with low commodity prices and low inflation will imply a huge difference in the performance of EM’s and DM’s. Low commodity prices should have boosted the growth in the EM’s that were not overly dependant on exports. However QE1, QE2, QE3 combined with the money printing binge of the Bank of England as well as the ECB led to the postponement of the entire process as asset prices, specifically commodities got unnaturally inflated over the last three years. At a time of demand destruction the performance of these commodities has been quite intriguing.

Although crude prices have been supported due to issues in the MENA reason and the Iran standoff still the kind of elevated prices that we see, especially in Brent crude reflects lot of price manipulation. I believe that the current probe that is on with regards to the fixation of Brent premiums could ultimately go the Libor probe way which will show huge price rigging.

The first step towards the outperformance of EM’s going forward was made post the reaction to QE3 where the expected runaway rally in gold and other commodities did not take place. The biggest headwind that EM’s faced over the last two years was the severe distortion in commodity prices due to huge amounts of free money sloshing around. But as it always happens the marginal impact of any measure reduces over time and as such in a scenario of low physical demand there is only so much that speculation could have driven commodity prices.

Post November 2010 inflationary pressures and the pressure on currencies due to the huge uncertainties in the Euro zones drove an underperformance in EM’s over the ensuing year and a half. The last 9-10 months has seen some sort of reversal in this trend where some EM’s have done very well and Indiahas also outperformed significantly since the beginning of 2012. I believe that the year 2013 will see outperformance from EM’s gather steam and move forward aggressively. Growth in Chinaseems to be bottoming out and although I personally do not expect a significant bounce in growth in Chinagiven concerns on exports as well as issues related to bad loans in the books of banks in China. Too much of infrastructure build up has happened in China without any botheration on the usage of these assets and returns from them. However strengths in China continue to be the strong fiscal position of the government, low reported inflation (believe it or not), a high savings rate and a moderation of asset inflation specifically housing prices. As such concerns on a hard landing in China seem to have abated as of now. Although it is very difficult to analyze the Chinese economy very deeply due to the closed nature as well as strict controls by the government, assuming a large scale manipulation of data would be wrong. The forex reserves of Chinaare real, the overall development and exports are also real. The kind of growth in the luxury market that we see in China could not have happened without real growth in income levels. However a move away from huge overinvestment is likely to keep a lid on commodity price inflation.

Now I come to the main point of the article. Most Western economies have postponed fiscal adjustments or done it in a half baked manner till now. Specifically the issues related to the US fiscal cliff are real and that is the largest economy in the world which has not done any significant fiscal adjustment till date. As fiscal adjustment starts in the US, which under the Democratic President is supposed to mean more of government and increase in taxation it will have an impact on USgrowth. The good part is that at the time when the fiscal adjustment is starting in the USthe financial system is in a healthy position and that crisis seems to be behind us. UScorporate sector is healthy with strong cash positions. The housing and labor market also seems to be recovering as per the latest data points. Under the circumstances the USis unlikely to face the issues that Euro zone has faced where financial conditions remained stressed along with fiscal adjustment. A combination of reducing private demand along with fiscal contraction is the most disruptive policy combination which is likely to put the growth in the Euro zone under continued stress. The good part, at least lately is that ECB has become more aggressive with the OMT announcement and the financial stress has reduced. As per yesterdays ECB press  conference flow foreign money into Italian bonds has also picked up over the last two months along with reentry of US Money market funds. This has happened after a considerable gap.

Under the circumstance I see two things happening. Firstly, growth and growth outlook will continue to remain subdued in the West for some time to come. Profits of companies in the US might come under stress if taxes are increased which could pressurize the stock markets. However the continued low interest rates combined with low financial markets stress and abundant liquidity will mean increased flow of money into Emerging Market assets. As such flows to EM’s will remain strong and pickup in 2013.

Specific to the Indian context there are a lot of positives that are likely to play out over the course of the next calendar year.

Improvement in profit margins –Unlike the Western economy companies where the companies were enjoying record high margins driven by low overall input costs, low wage inflation and extremely low borrowing costs the profit margins of companies in India went to 8 year lows at the beginning of the current fiscal year.  The current quarter results reflect the first part of the improvement where the stabilization of the INR combined with low commodity prices have seen gross margins stabilize or improve. I believe that this improvement in gross margins will continue well into the next year and going forward. What this will imply is that gross profit growth will be much higher than topline growth.

Interest costs stabilize, to move down – The second level at which company profits were hit was due to continuously rising interest costs and tight liquidity. This is likely to reverse big time next year where interest costs during the course of the year should decline at least 100 basis points in terms of policy rates and 150 basis points in terms of actual borrowing costs of corporates. As liquidity eases and the economy starts its recovery we could also see some improvement in the working capital cycle. As such the phenomenon of interest costs eating into operating profits growth is likely to reverse next year.

Maybe some impact of policy initiatives – The government has announced a number of policy initiatives, which if taken to the logical conclusion are positive for economic growth. The recent move forward on the setting up of the National Investment Board and also the conciliatory tone of the Finance Ministry on the GST issue as per today’s media reports is positive overall for the economy and the markets. The huge movement on addressing the subsid
y issue with direct cash transfers which I wrote about the last time can also go a long way in addressing the fiscal deficit and boost growth. However we need to watch the progress in this to get to any final conclusion.

The money tap is still open – The money tap is still open globally and with easing financial conditions more of this money is likely to flow into high yielding assets of EM’s. This will have the impact of boosting asset prices as well as provide equity funding for growth which has been lacking for the last two years.