The world economy grew by $14 trillion between 2010 and 2017 according to the World Bank.1 While $4.4 trillion of this came from North America and $0.5 trillion from Europe, the emerging markets accounted for the majority of this growth. The biggest contributor was China with $6.1 trillion, but India at $0.9 trillion, Korea at $0.4 trillion and Indonesia at $0.26 trillion were bigger contributors to growth than Germany ($0.26 trillion), for example.
Over the summer, the market seems to have lost confidence in the continuation of this trend. The Turkish lira dropped 43% year-to-date to August 31 and the Argentine peso fell even further. The major Chinese indices have fallen 18% year-to-date and “Dr Copper” is also down close to 20%.2
Two notions drive the sell-off. On the one hand, countries with significant capital and trade deficits like Turkey and Argentina are under pressure through a combination of high USD-denominated debt, rising oil prices and inadequate policy responses. On the other hand, countries with significant trade surpluses, like China, find themselves under pressure from a fundamentally remodelled U.S. trade policy.
As always, we do not claim to be able to predict the outcome of these challenges and our investment approach remains bottom-up. Nevertheless, given the portfolio’s significant – albeit indirect – exposure to emerging markets, we must consider the risks to these markets and have reviewed the portfolio in light of the challenges.
This is not the first time emerging markets have experienced a setback. It is unlikely to be the last. Investors may remember the last time this happened, back in 2013. Then, as now, we focus on the fundamentals. We believe the main levers to help protect against the risk of capital destruction are pricing power, long-term structural growth trends rather than short-term shifts, recurring revenues, high sustainable returns on operating capital and valuation:
We select high-quality companies we believe have (i) pricing power, (ii) high and sustainable returns on operating capital to fund innovation and investment, even in periods of slower growth, and (iii) are reasonably priced. This gives us some comfort that our portfolios will display the level of relative downside protection displayed in the past, should it be needed.