Economic Recovery and the Inflation Debate in Emerging Markets

Transcript

Stephen Dover: First of all, with you Alastair, of course, the biggest question is around COVID and the Delta variant and how that is impacting emerging markets. What are your thoughts on the impact and where you see opportunities perhaps around that?

Alastair Reynolds: You know, the opportunities, I think, have become increasingly clear over the last 12 months or so with the growth of internet-enabled businesses, e-commerce, et cetera. I think, now that's been with us for 18 months, what we are really looking forward to is the, what we would say is, emerging markets reopening trade. And, I would point to maybe India as an example of that.

We had retail numbers out of India, and they're showing that things are tracking, retail sales, roughly, about half the level of the pre-COVID levels. So, I think what I'm looking at there is that we’ve got an indication that things will start to grow. And as things go back to normal, that there's a lot of catching up still to be done in those kinds of markets.

Stephen Dover: Andrew, I think when people read the headlines, the news is so bad about the Delta virus. Alastair just mentioned India. Now, we're hearing about Indonesia. But, the actual performance of emerging markets has been very good this year and these countries seem to be bouncing back. What are your thoughts about how the virus is affecting how you think about strategies?

Andrew Ness: You know, obviously, COVID, it sadly continues to dominate the headlines and it does feel a little bit like Groundhog Day. I think I mentioned this time last year that we expect COVID to remain prevalent for the year. And, it seems to be very much the case again. And while some countries in emerging markets have made solid progress with the inoculation, what we're seeing is that the production and distribution of vaccines in sufficient scale are proving to be challenges of a similar scale to the development of these vaccines. So as a result, I think we can expect many countries to continue experiencing sporadic COVID outbreaks. That's going to add volatility to the underlying trend of economic and market recovery.

You know, it might sound like doom and gloom, but let's put that in context. We think that emerging markets are still likely to remain resilient in the face of this challenge and you have to look at many factors that we've discussed in the past about the resilience of the emerging market opportunity set. The economy still remains much less indebted than developed economies. And, that’s at the sovereign level, it’s at a corporate level. and the household level. If you look at our banking systems across emerging markets, they've largely withstood stress and that's despite the moratoriums that have been imposed upon banks across the board.

As Alastair mentioned, we've got the reopening trade that’s supporting the technology and consumption themes that have become the new drivers of economic growth for many emerging markets and all of that is leading to a sharp earnings rebound that we’d expect from very much a low base last year.

Stephen Dover: Alastair, of course, with the virus continuing, many countries have had different monetary or fiscal stimulus. How are you thinking about that?

Alastair Reynolds: Well, we think about that in a couple of ways, Stephen. On the first side, the fiscal side, the biggest fiscal packages came from the developed markets. So, really, it's about making sure that the stocks that we're in, in our strategy, are going to be beneficiaries of that uptick in spending so that the, kind of, Biden infrastructure plan being an example of that. So, actually a developed market led fiscal expansion, they have the capability to do that.

On the other side, really, what we've been looking at, domestically in emerging markets, in terms of how things are playing out in their own domestic economies, it's really come down to the extent to which the banking sector, the local domestic financial sector, will be used as an intermediary in providing, you know, alleviation to the corporate sector.

So, there we were looking at sectors where there was a strong foreign influence that, you fall victim to nationalism, if the local government favored, you know, putting a bigger than normal price onto a foreign owned banking sector. Mexico would be an example of a banking sector like that.

And then elsewhere, we've been looking at, you know, banks’ ability to participate in assisting the governments in debt moratoriums and really having strong balance sheets to see themselves through the first stages of the crisis. What we're then looking for is a bit of relaxation of regulation as we go further through the recovery for governments to allow the banks to march out of this support structure in a way that's conducive to their earnings.

Stephen Dover: So, Alastair, are there particular countries where you're more or less positive on the financials?

Alastair Reynolds: Yeah, sure. So, we see banks as one of the real areas of outstanding value in emerging markets overall. We also like, particularly, banking systems where the banks are well capitalized. So, you're getting that valuation attraction, but with robust bank balance sheets. And then, that translates into, you know, certain markets will have been much more positive than the banking system than others. And I would single out really India as one, where we think there is such a gulf between the private sector banks and their relative balance sheet strength compared with their state bank brethren, you know, that's been a market where we think that they can really take market share in this environment, as well as managing to navigate the crisis.

Stephen Dover: Andrew, how about you and your team? How are you looking at banks? And, what countries are you finding more or fewer opportunities?

Andrew Ness: We've seen banks as an attractive way to play the emerging market consumer opportunity. We still see a number of our major emerging market economies are significantly underbanked, i.e. very few people still have, you know, credit cards, very few people have mortgages. Even very few people in many countries have deposit accounts. So, there's still a process of “banker-ization” as we could call it to take place in many of our countries. And, that reflects one of the many under-penetration stories that we look to exploit.

If you look at banks and how they’ve fared, they obviously were considerable casualties of COVID, given the impact of government policy. We had the moratoria that I mentioned earlier, we've had interest rates being cut to support borrowers, we’ve had some debt forgiveness programs, et cetera, et cetera, and with the underlying economic contraction itself, which clearly creates a negative credit environment. But looking forward, as we all hopefully do, we look at the banking sector with more optimism and we should expect to see banking sector returns expanding, you know, in some cases fairly rapidly over the next two years and that's because we expect provisions will start to normalize. Some banks will start to see large recoveries because of, probably, being too prudent and provisioning during the downturn. We'd expect to see significant loan demand recovery. And in addition to that, we've got the digitization theme and that's going to keep a lid on costs for many banks.

And, when we start to look at the inflationary environment and if you do start to see rising rates, then clearly we've got the additional potential for net interest margins to start to expand. So I think it's a reasonably constructive environment for many banks.

Stephen Dover: Alastair, China came out of the COVID crisis before almost any other country and is actually, to some extent, tapping the brakes. What's your outlook on China? How are you approaching it at this point?

Alastair Reynolds: Yeah, so our outlook on China is one of continued growth. We don't think their growth has, in any way, peaked. Although that growth will come at a slightly lower rate than what we've been seeing in recent quarters. We've seen that through in China with a slight tightening of credit provisions. So, we think that's timely. We think that the economy is recovering under its own steam.

I think there's a couple of areas there, on the one hand, in mainstream offshore, so Hong Kong-listed, or US-listed Chinese names, our focus has been very much towards large platform, internet e-commerce, that kind of areas of the market, very much playing domestic Chinese demand, whether that be in business or in consumer.

But also, I think there's a real opportunity in the domestic Chinese markets. That would be through the A-share exposure, where there's much higher focus on fast-moving, innovative companies. So, areas like health care we find very exciting given China's aging economy, but also in technology, which is another theme that we're seeing in China. Technology is this self-sufficiency, national self-sufficiency, albeit, maybe, forced upon them, but we're certainly seeing that as a theme worth following up on in China.

Stephen Dover: So, Andrew, I know you also have followed China for a long time. Where are you seeing opportunities there and what sectors are you looking at?

Andrew Ness: We see considerable growth opportunities across a range of areas whether that's e-commerce, it's gaming, it’s payments, it's the cloud computing companies, it’s cybersecurity. There's a whole host of growth opportunities that we still see very clear.

The feedback that we've had from our analysts on the ground and from the companies that we've been engaging with is still that they see strong growth opportunities persisting. There's still confidence in the current and the future demand outlook and I think that's slightly contrary to that the market's more bearish view, perhaps.

Many companies still believe that they can manage their input cost pressures effectively, and again, that's something of concern, given the rising input costs that we've experienced across many markets.

And then, finally, we're seeing a great deal of corporate activity by many Chinese businesses. You know, well-managed companies that have got strong balance sheets. They look to have emerged stronger from the pandemic, and we're seeing plenty of opportunities to deploy capital towards growth. So, I think we're still pretty optimistic about many of the private sector businesses that we continue to back in that market.

Stephen Dover: Of course, there's been a lot of geopolitical change, recently. Andrew, how do you factor in political risk into your decision-making?

Andrew Ness: Fun question, and one that's fairly common for most of my career in our asset class.

Certainly, if you look at China and the regulatory environment, it has been extremely noisy, and I think the headlines can be worrying. But, you know, ultimately, we've not changed our views on the market leaders. and that's because the internet sector has repeatedly demonstrated that businesses that offer better user experience and a much more efficient business model ultimately prevail in the end. And our analysis is that these businesses still create significant value for both the users of the platforms or consumers, but also the merchants that find their way to market via these platforms. And there lies the foundation for the sustainability of their earnings power.

When we look more closely at what's happening from the regulatory front and how we think about it, we've really got to understand the motivation behind these investigations. And, there's really three main things that are happening today in China.

Firstly, you know, the communist party is drawing a very clear line in the sand to remind everyone who's in charge—not that anyone should have forgotten who is in charge. And it very much remains the Communist Party of China who remains in charge and will not be tied to anyone who dares to think otherwise. Now, in addition to that, you know, this month saw the hundredth-year anniversary of the communist party and there's a clear focus to enhance the party's leadership role in society. And what that means is a much greater focus on reducing inequalities to demonstrate obvious improvements in living standards. And what that means now, is that we're seeing various government agencies having mandate to focus on data and privacy, a goal of promoting competition and protecting consumers, you know, the small businesses and those gig economy workers.

Now, we'd argue that that's not anything that's Chinese specific. You could say that, you know, China's catching up with the rest of the world in so far as this new global internet regulatory environment goals. And, we've seen various antitrust lawsuits against some of the larger developed market platform companies. So, I think there's lots going on in China. I think another thing that's going on is the fact that Chinese firms look to be actively being discouraged from listing in the states now. And that seems to be a clear response to pressure from the Biden administration. And, it just strikes us that the Chinese are doing all that they can to ensure that their corporates are much more focused on capital raising domestically, and we see continuing deepening of the domestic capital markets it should facilitate that.

Stephen Dover: We have a lot of questions about inflation. Are you seeing evidence from companies that support the view that inflation is rising?

Andrew Ness: Yeah, I think we're certainly seeing signs of inflation throughout the asset class. And that's a reflection of supply bottlenecks, ongoing shipping disruptions, but also the recovering demand that we're seeing in many economies. So, it shouldn't surprise anyone that we're seeing an uptick in prices. In addition to that, you've had obviously the very strong commodity background that's lifting headline inflation. Our expectation is that should ultimately prove transitory, and we look for inflation to moderate going forward, but, it's certainly not something that we spend a huge amount of time forecasting. What we are seeing is a policy response from certain parts of our asset class, they have started to tighten, other parts of the asset class are more willing to wait. And I think if you look at the recent US Treasury market action, you know, it seems that growth and not inflation is the current concern for investors. You know, that could obviously change if we talk about this in a month’s time.

If inflation does persist, however, is it a big risk for emerging markets? I think that's the key question. And, you know, our view would be it all depends on what type of inflation we're experiencing. And there's two very different views. There's the benign version, which argues you should experience some inflation as there's a natural global recovery post the economic lockdown that we went through, but that won’t generate sufficient long-term inflation concerns. And then you get the much more sinister scenario that sees continued overheating because of low interest rates and fiscal push, this snap back in demand, much stickier inflationary pressures, and you start to see an elevation of core rates. I think I'm personally sympathetic much more to the more benign scenario—important to note that we see these things as a source of risk, not source of alpha. But I think there remains significant slack and spare capacity in most economies and I think especially on the labor side. So, we'd argue that it's difficult to see this recovery leading to significant and persistent upward pressure on wages. So, if that's the case then, I don't think we should be too scared about an upward move in inflation across much of emerging markets. We'd see it as an expected part of the economic normalization process post the crisis.

Stephen Dover: So, Alastair, let me ask you another inflation question, and that is if you can distinguish in your assessment, the difference between corporate or input costs versus consumer or end user costs on inflation trends. So in essence, PPI versus CPI, or maybe another way to ask the question is, are corporates able to pass through the increasing cost of their inputs?

Alastair Reynolds: Yeah. So, it's pretty early stage yet to tell the answer to that. So what we can see for sure, particularly in the developed economies, is that there is this pent up demand for goods that are in very short supply. So, those bottlenecks are coming through and you you've got that demand pool inflation that's present. So, you can see that in any goods that were being shipped from Asia and coming from supply constraint areas. On the producer side of things, it is really most evident in the raw material space. So we've seen sharp year-over-year increases in areas like copper and coal, in iron ore prices and steel prices. And what really, I think, caught corporates by surprise there is the resilience in those prices at the second end of last year.

And that's really China's hand in the markets. China, really was a big consumer. It added pretty much 10% of consumption power to those raw materials in the second half of last year at a time when the rest of the world was minus 10%. So that's led to this increase in producer prices that's now starting to feed through into the manufacturing sectors, discretionary sectors, and it's really from now on that we're starting to see whether those companies have the pricing power to pass that forward to their end consumer or not. So, you know, I think that’s why markets are so volatile at the moment—it's that the evidence of current high prices is everywhere. We just see it everywhere we look, but there is no evidence yet of how sustainable that's going to be.

Stephen Dover: Alastair, one of the great joys of my life has been working in emerging markets over the last 35 years now and seeing the growth and development, particularly the economic growth. But of course there's been some costs with that in terms of environmental impact and others.

I know, Alastair, that your teams and your strategies have looked at ESG factors over a long period of time. So maybe you can talk about how do you incorporate ESG, and how do you balance making ESG investments versus the decision to really help these countries with their earnings growth and with their GDP growth?

Alastair Reynolds: I guess for any emerging markets investor, ESG has always been a big, big issue to deal with. It started off, I guess, with governance and the fact that the shareholder who you would be sharing the register with would typically be a government and ensuring that your minority investor interests were being appropriately attended to when you were investing alongside them. Then it moved into more social factors in terms of use of labor and community rights, as a lot of the natural resource companies were prominent in emerging markets. And now, very much we've moved into the era where it’s the “E” of the ESG that's grabbing all of the headlines. So, when we look at it, we are long-term investors, we're looking over a five-year plus horizon. And the way that we deal with that is we will not spend any significant time on a business where we don't believe the management team has its eyes wide open to the environmental, social, and governance risks that are coming down the pipe to it in the future.

So, the way that we then incorporate that is really by identification—identify what the material risks and opportunities are and engage with companies to ensure that they are making the best of that opportunity that presents itself to them and mitigating risks where possible. Now, that's likely to come into play very much so in the next few years, as decarbonization becomes the specific theme within the environment where we're going to have to work hand in hand with companies to pursue decarbonization strategies at a time when, if we had asked them maybe five years ago, many of them would have felt that they had many years of high carbon usage still to come. So, I think we're going to have to find companies that can adopt technology. And I think that's one of the areas, renewables technology is going to be an area that is really going to aid the adoption of decarbonization and electrification of much of the energy usage that goes on in emerging markets. But I think China will be at the forefront of that. That's one of the other areas that we were talking about—what makes countries attractive? I think China because of its scale, because of its preexisting activities in many of the renewable technology areas, is really setting out it’s stall to be a globally dominant producer of many of the necessary renewable technologies of the future.

Stephen Dover: Thanks, Alastair.

Andrew, Templeton is very famous for—since the beginning of its Emerging Markets Group—as really focusing on governance. But I know also you have a focus now on the environment and the social issue. Can you just talk a little bit about how strategies within Templeton look at ESG?

Andrew Ness: Yeah, sure, Stephen. I think the way that we sum it up is ESG analysis is very much an aspect of our overall approach to our stewardship of our clients’ assets. The way we think about stewardship is our clients are entrusting us to look after their assets, and we have a responsibility, a fiduciary and a stewardship role, to look after those assets until the point in time when the client asks them to be returned. And our ambition should always be to improve the quality of those assets under that stewardship. That requires us to very much integrate material ESG factors into our research, pretty relevant. It requires us to act as engaged and active owners in corporates, protecting our clients’ interests. And that often requires us to vote actively against corporates when we disagree with the direction that they're taking. And as you quite rightly say, Templeton had a long history of engaging actively with corporates across emerging markets. I think we benefit from the long-term relationships that we have with many of our portfolio companies. We benefit from the awareness that companies have of us as being a long-term investor, and that's very important. We're not a short-term speculator into this asset class. We've been investing in it for over 30 years for our clients. So, when we engage with corporates, there's a real willingness for them to listen. I think the ability for us to do this in emerging markets is always challenging as Alastair will no doubt appreciate it, is hard to do. And I think particularly, when we're looking to satisfy all stakeholder interest, because when you start to look at the real world, then you start to get lots of conflicts of interest and complexity, and particularly in emerging markets where I think cultural context vary, as do their stages of development from an economic governance and regulatory perspective. And I think that reality can pose challenges for investors and owners when they’re seeking to engage for multi-stakeholder outcomes. The way that we approached this is being very patient and be very long term, but also working where we think we can achieve change with companies and identifying material areas for them to focus on. But, yeah, it's constant work in an area that we continue to evolve and expand our practice towards.

Stephen Dover: Thank you, Andrew. Thank you, Alastair, for joining us. Thank you very much.

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