Picking winners in turbulent times

In this article we cover:

• Why populism has risen and the repercussions for global trade and the international value chain
• Why the current political climate is supportive for emerging market investing
• How Asian companies are particularly well-placed to benefit from changing patterns of commerce

This year, around 60% of global economic growth will come from Emerging Markets[1]. Their contribution to global output has risen remarkably, particularly over the past twenty years, but while the benefits are well documented – improving rates of mortality, longevity and literacy, for example – globalisation has also brought challenges, including a rise in populism.

1) World Bank Estimates, January 2017

The roots of global political turmoil

The recent shift in political ideology away from traditional establishments, which are seen by many as having failed, in favour of empowering the masses is rooted in several causes. First, globalisation has not led to converging values.

While developed nations have generally become more tolerant and embraced equality and self-expression over the past twenty years, many less developed nations, particularly in Africa and the Middle East, have placed greater emphasis on more traditional institutions like religion and family. These cultures often display higher levels of national pride and a more insular outlook which values economic and physical security, often at the expense of trust and tolerance. Their 'survival mode' behaviour has intensified over the past two decades leading to a divergence, rather than convergence, of values.

Second, most 'Millennials' do not believe democracy to be particularly important, with less than 30% of Generation Y in the UK, US and China believing it to be 'essential' (see chart). This is much lower than previous generations who experienced global wars and conflict throughout large parts of the twentieth century. Social media gives the younger generation a platform to express real-time opinions and connect with those who share similar views, replacing the traditional means of democratic expression. This helps to explain why many opinion polls ahead of recent major political events were wildly inaccurate.

Third, we may be entering an era of mercantilism without direction from a major 'superpower'. Historically, periods with a dominant power have tended to coincide with global peace, such as the British empire throughout the nineteenth century and US strength following the Second World War. Under Donald Trump, however, America now appears to be retreating from a position of global strength at the same time as increasing military spending, leading many to question the stability of international relations and the potential for conflict.

Fourth, globalisation has been unkind to the developed market middle classes. While the middle classes in the emerging markets and the most affluent segments of the population of the developed markets have benefited from increasing international trade (see chart which shows global income growth relative to income distribution), the developed market middle classes have seen wages stagnate. This group represents a significant number of disgruntled people whose desire for political change helped drive Brexit in the UK and the election of Donald Trump in the US.

Value chain complexity

While both developed and emerging worlds cautiously await details of Donald Trump's new US trade policies, it is worth reflecting that globalisation has caused value chains – the processes by which companies add value to product development – to become increasingly international and interdependent. At the bottom of the value chain is the 'middle income trap', where countries can become stuck in assembly and manufacturing. However the more valuable parts of the chain are in the controlling of patents, marketing, innovation and brand ownership and we have seen Asian economies moving further up the value chain in recent times.

The electronics industry is a good example of increasing value chain complexity. Consider the iPhone – 'Designed by Apple in California' and 'Assembled in China' – where Apple takes the lion's share of profits and companies like Samsung Electronics benefit by providing key components in the phone's value chain while the Chinese assemblers only capture an estimated 2-3% of its profits. Although China's proportion of US imports has risen from zero to around forty percent in just over twenty years (see chart), the logic of America attacking the bottom of the value chain by introducing trade restrictions is questionable. In contrast to China, which has generally been moving up the value chain in recent years, Trump seems intent on building and protecting US manufacturing capacity at the lower end. A trade war with China would also spill over to other economies and see US private sector employment fall by an estimated 4.8 million jobs, or more than 4%, by 2019 [2].

2) Peterson Institute for International Economics

Pragmatism to trump protectionism

Asian nations are increasingly dependent on each other for trade and less so on other regions, including the US. While standards of living and wealth are increasing across Asia, the number of affluent Chinese households is expanding exponentially (see chart). This growth will continue as China moves towards a fully-fledged service economy and the US will not want to limit their exposure to it; pragmatism should prevail and we could see trade arrangements between the US and specific companies and regions in Asia. Although there is likely to be a period of short-term volatility while this takes place, the long-term rewards for and from the region should be significant.

America's relationship with Asia is uncertain in this period of international political and economic turmoil. The rise in populism – while perhaps unsettling for many people in developed markets – creates opportunity for emerging market countries and the companies that operate there. They are increasingly less reliant on developed markets for growth and many now occupy more profitable areas of the value chain while the balance of international wealth and power is also changing in favour of the developing world.

Corporate governance key to unlocking Korean discount

Applying environmental, social and governance (ESG) investment principles could unearth significant opportunities in Korea, where despite a highly-advanced economy, family dominated companies mean that corporate governance is currently sub-standard. The country's largest nine companies are so-called 'chaebols' which represent 60% of the Korean stock market and whose combined revenues contribute around 75% of GDP. This long tradition of control, concentrated in the hands of such a small group of families, has been the source of many conflicts between shareholders and companies, resulting in a large 'Korea discount' (see chart):

However, new legislation is set to address the problem with several initiatives, including:

• A requirement for Board independence
• The limiting of family access to corporate cash
• Reinforcing the national pension system and creating a more shareholder-friendly environment to benefit minority investors

These welcome changes should see the Korea discount narrow as governance improves; we estimate that Korean stocks have 30-40% potential upside as excess balance sheet cash unwinds and dividend payouts potentially increase.

Given changing global risk-reward dynamics and significant opportunities in individual companies and market segments in the developing world, the risk for investors is arguably being underweight emerging markets and the challenge is how to find the best risk-adjusted exposure. In our experience, an active, bottom-up strategy, which seeks out the strongest companies at the most attractive valuations, is always the optimal way of picking the long-term winners.

___________

IMPORTANT INFORMATION

This article is intended for investment professionals only. The content is not to be viewed by or used with retail investors.
Except otherwise stated, the source of all information is SKAGEN AS as at 28 February 2017. Data has been obtained from sources which we deem reliable but whose accuracy is not guaranteed by SKAGEN.
Statements reflect the writer's viewpoint at a given time, and this viewpoint may be changed without notice. This article should not be perceived as an offer or recommendation to buy or sell financial instruments. SKAGEN AS does not assume responsibility for direct or indirect loss or expenses incurred through use or understanding of this article. Employees of SKAGEN AS may be owners of securities issued by companies that are either referred to in this article or are part of a fund's portfolio.
Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager's skills, the fund's risk profile and subscription and management fees. The return may become negative as a result of negative price developments.
Issued in the UK by SKAGEN AS. Authorised by Finanstilsynet and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our authorisation and regulation by the Financial Conduct Authority are available from us on request.