How to navigate emerging markets

Michael Hasenstab, Ph.D.
Chief Investment Officer
Templeton Global Macro

Put simply, we focus on countries that we deem to be fundamentally strong but, for one reason or another, are out of favor with investors

This article was first published in InvestmentNews on September 26th, 2016.

One question my colleagues and I are often asked is how we select which countries to invest in, as some of our best known investments — such as Ireland, Ukraine, Hungary and, most recently, Brazil — have not necessarily been obvious choices.

The answer lies in a formula that we have developed and honed to help us identify countries that appear to be better off than most people appreciate, or are on a path to improvement that the market seems to be missing.

Put simply, we focus on countries that we deem to be fundamentally strong but, for one reason or another, are out of favor with investors. They are otherwise robust economies suffering through temporary difficulties obscuring their underlying strengths.

Our formula, which we call the Local Markets Resilience Index (LMRITM), employs a proprietary scoring system to evaluate the fundamental strength of different emerging-market countries.

This index focuses on a country's ability to weather the external shocks facing it, such as slower global growth, higher financial market volatility, lower commodity prices, lower global trade flows, the prospects of higher US interest rates, and a shifting growth model in China. This involves scoring each country on its current and expected performance across five key characteristics, with the best opportunities being those that produce a strong total rating.

The first characteristic is lessons learned — how well has a country processed and assimilated the experience from previous crises and used that knowledge to inform current policy. Take Mexico, for example, one of our favored investments, including the historic low levels of the peso. It is a textbook case of a country that has taken to heart the lessons of prior blow-ups.

In the wake of the tequila crisis of the mid-90s, as well as other economic disasters, successive regimes have made great efforts to reduce macro-economic vulnerabilities and launch structural reforms. As a result, Mexico adopted a more flexible exchange rate, built up foreign currency reserves and cut short-term debt.

The second characteristic we consider is policy mix. We evaluate the quality of policy-making, examine the central-bank independence and assess the broader political environment. We like to see governments make tough decisions. We invested in Lithuania, for example, because its government was prepared to make many unpopular decisions that caused short-term pain, but were vital for longer-term recovery. These included stark, but necessary measures such as cutting public-sector wages, implementing pension reform and raising taxes.

Related to this is the third characteristic, structural reform. What is a government doing to boost productivity? While we are optimistic regarding Brazil's long-term prospects, this is one area where there is significant room for improvement given the combination of deep recession and political turmoil. However, it stands out to us as a vulnerable market poised for a potentially significant rebound. The country's top priority must be to restore political stability, but once this has been achieved, work on reforms should begin quickly. This may be enough to placate the country's growing middle class, who want to know how whoever ends up running the country plans to boost living standards.

Fourth, we weigh the level of domestic demand — how large is the economy and is it well placed to withstand external storms? Indonesia scores highest among all of our emerging-markets investments for this, both for current and forward-looking demand. Growth has remained strong in recent years, and favorable demographic trends indicate that this trajectory should continue for some time to come — just 5% of Indonesia's population is over the age of 65.

The final characteristic we measure is external vulnerability. How susceptible is a country to external shocks? We look for as much insulation as possible, with a focus on factors including foreign debt levels, dependence on commodities, and how these factors can stave off a balance of payments crisis or capital flight.

Malaysia is a prime case of a country with less external vulnerability than that perceived by the market, thanks to its high degree of export diversification. For example, despite the large commodity-based export sector and the collapse of those prices, the country maintains a balanced current account due to the development of its manufacturing export sector, particularly electronics.

We have long held the view that it is a mistake to regard emerging markets as one homogenous group.

These five characteristics are part of the toolkit we use to identify and evaluate the most compelling investments — those nations that are fundamentally strong, but experiencing temporary difficulties, rather than those that have more fundamental underlying problems. We believe that taking the time to assess emerging market economies on their individual merits can prove a more rewarding endeavor and lead to more fruitful opportunities for us over the long term.

Dr. Michael Hasenstab is Executive Vice President, Portfolio Manager and Chief Investment Officer of Templeton Global Macro.

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