Just like a classic pair of leather trousers, or a crimson roll neck, fundamentally sound purchases can often make you look a little silly at various stages of a cycle – as it is with financial markets. For many months now this blog has raised concerns over the outlook for the developing world. Such caution has helped us avoid much of the pain incurred over the summer months as fears of a Chinese hard landing, and the withdrawal of international funding, lead the asset class sharply lower. Since their 2013 lows in June, however, Emerging Market equities are up nearly 15% in dollar terms. Though developed markets are up an impressive 10%, the shortfall makes us question whether the outperformance is merely temporary, or if something more structural is playing out?
My first thoughts would be to never underestimate the fiscal resources of the Chinese authorities. Though the new leadership have recognised the current economic model, driven by rapid credit expansion, is leading to further over capacity (in areas such as real estate and steel production), the transition to something more sustainable is proving a painful one, and must be managed carefully. It is evident, therefore, that since the summer’s clampdown on the shadow banking system, state induced lending has once again picked up, and approvals for infrastructure projects, such as high speed rail, are on the rise. Though we have not seen anything on the scale of the 2009 stimulus package, these measures have been enough to arrest the deceleration in growth, which now looks to be settling in the 7.5% range.
These cyclical efforts have helped alleviate concerns of a Chinese ‘hard landing’ (at least imminently) and lifted valuations across the board. Whilst the respite is welcome from some quarters, the net result has been a scaling back in the pace of economic reform. The Chinese banks, a clear tool of government, are continuing to direct lending to local authorities starved of cash. Along with a state permitted increase in land bank sales, local authorities are able to continue funding the negative cashflow projects so poorly selected during the 2009 stimulus. Though this will surely lead to an increase in non-performing loans at some stage in the future, it will at least help to keep employment levels elevated in the short term. However, the channels to direct funds to the Small and Medium Size Enterprises, the heartbeat of any capitalist economy, remain closed.
This theme of State Owned Enterprises (SOEs) poorly deploying capital to achieve better short term economic outcomes is endemic within Emerging Markets. Share prices have recognised these inefficiencies to such an extent, however, that they are significantly dragging down aggregate valuations, and are now unjustly luring unsuspecting investors.
The above chart highlights the scale of the derating the major SOEs have suffered over the past 8 years (the time table chosen reflects the Chinese banking IPOs initiated around that time). This has weighed heavy on markets both directly and indirectly. SOEs have not only been poor allocators of capital themselves, their actions have interfered with pricing structures, and therefore profitability, across swathes of industries. The selected names in the chart do not, for example, include the Brazilian utility companies instructed by authorities to reduce electricity bills. Nor does it include the array of private credit institutions which, faced by a drop in interest rates from state managed banks, have had to cut their own margins or, in many cases, drop down the quality curve to maintain them.
The poster child for all that was to be aspired to in Emerging Markets was Brazil. Many may recall the front cover of the economist some five years ago, adorned by a picture of Christ the Redeemer - complete with rocket boots. The intention was to showcase the powerful tailwinds behind the Brazilian economy. In the end this proved to be a fantastic contrarian indicator. The demise of Brazil is no better explained than in the performance of one its own major State Owned Enterprises, PetroBras. This company, with all its bountiful reserves has suffered a startling fall from grace. Though championed by many fund managers for its productive potential, over the past 7 years it has not been able to produce a single positive free cash flow figure. Admittedly the deep water programmes were certain to be capital hungry, but decisions to ‘Buy Brazil’ in terms of both labour and infrastructure have meant unnecessary cost escalation. Further to this, state control of downstream diesel prices meant margins were artificially tight.
Though the cap on diesel prices was raised earlier in the year, not enough structural reform is being undertaken within this company, within the wider economy, or within Emerging Markets, for us to get excited by valuations. SOE priorities are not controlling costs or maximising profits, instead it is full employment and implementing state policy. This does not make them inherently ‘evil’ companies, but given shareholder return is not the key driver within the management decision making process, we would continue to avoid a structural overweight position. Fortunately, many leading active fund managers have observed these conflicts and are enjoying consistent market beating returns as a result.
*Top ten SOEs by market capitalisation. Contribution weighted by market capitalisation.
Head of Fund Research