Why we remain bullish on emerging markets long-term

AS we examine the emerging markets landscape today, the rise of leverage within economies is a key trend we have witnessed. Leverage can be a double-edged sword, as it can be positive, but also represents a source of risk. Over the past decade, the level of debt has gone up not just in emerging markets, but across the world. Covid-19 has certainly led to a dramatic increase in government debt in some countries, but in general, debt to gross domestic product (GDP) is currently much lower in emerging economies than in developed countries - which is one reason for our bullish view.

Aside from an increase in China, corporate debt as well as household (consumer) debt levels in emerging markets are still much lower than in the developed world, too. As such, we feel that emerging markets have much more headroom available to further increase debt levels without a significantly detrimental impact.

Turning to the structural opportunity this presents, the credit ratios in Latin America and emerging Europe are much lower as a percentage of GDP compared with both the developed world and emerging Asia. This is the reason Latin America and emerging Europe have looked appealing to many investors despite some headwinds. Mexico, for example, boasts a debt-to-GDP ratio of less than 50 per cent, and while Brazil's debt-to-GDP is around 100 per cent, it is still much lower than many developed countries. We see a similar story in Eastern Europe, where debt levels are lower in Turkey, Hungary and Poland than countries like Japan, Australia and France, for example, where debt-to-GDP ratios are above 150 per cent.

Emerging market equities also hold attractive valuations - another reason for our bullish view. They trade at a discount to the developed world despite strong growth potential and headroom for credit consumption. The forward price-to-earnings (P/E) ratio for emerging markets, as measured by the MSCI Emerging Markets Index, stands at around 13, whereas developed stocks, as represented by the MSCI World Index, have a forward P/E ratio of around 19.

Valuations in Eastern Europe and Latin America are even lower - and not just on an absolute basis, but even relative to their own history. Latin America is rich in natural resources and looks to benefit from the commodity boom taking place amid the recovery from the pandemic. The prices of most commodities have risen, which represents a natural tailwind for the economies in those regions, with improving terms of trade being one benefit.

Brazil is one of the world's leaders in iron ore production, for example. And Brazil - along with Argentina and Chile - also supplies the world with lithium, one of the most important metals in electric vehicle production. Chile and Peru are global leaders in the production of copper, another vital commodity in today's world that has seen increased demand.

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Similarly, countries in Eastern Europe - primarily Russia - are key commodity producers, including nickel, aluminium and, of course, Russia is a leading oil-producing nation. Much of the world depends on the commodities produced in Latin America and Eastern Europe, which should bode well for these economies and the companies within related industries.

Cash flows are another reason why we like emerging markets. In the last decade, emerging markets have underperformed the developed world in terms of return on equity. But for the last decade, there has been a trend of improving free cash flows (in both absolute terms and relative to developed markets) that has accelerated in the last year. Emerging market companies are generating much more free cash this year because both commodity-oriented and technology-oriented companies (in particular the semiconductor industry) have been doing well. As cash flows increase, we believe this ultimately will result in improved returns on equity for emerging market stocks and should likely propel a re-rating.

While we do see reasons to be optimistic, we should mention the near-term risks in our outlook. Regulatory changes happening in China have ramifications for a number of industries and many Internet-related stocks in particular. This is impacting earnings power in the near term, and also potentially further into the future.

And of course, we are still living with Covid-19 and the more infectious variants. We had expected that with rising vaccination rates, mobility would automatically resume. However, that hasn't necessarily been the case.

We would also note that while commodity prices have been very strong this year, they seem to be topping because of China's policy measures, as well as the global resurgence of Covid that has acted to suppress demand during lockdown periods. In addition, a dramatic rise in freight rates has had a negative impact on margins for many export-oriented companies.

In sum, we believe the long-term fundamentals for emerging markets remain attractive despite near-term headwinds, and that equities offer good potential for investors. While the economic recovery from Covid-19 could be more muted, growth remains historically strong, valuations appear cheap, and earnings prospects are supported by rising cash flows.

• The writer is senior managing director and director of portfolio management at Franklin Templeton Emerging Markets Equity.