Emerging-market stocks and currencies have taken a beating in 2015, but underperformance in these assets is hardly novel. The MSCI Emerging Market index hit its post-recession peak in 2011 and has been trounced by its developed-market counterpart since 2010:
It's easy to blame China for all the emerging-market woes, but John Paul Smith, founder of research firm Ecstrat, points to a structural reason for the underperformance of the asset class.
Emerging markets are now abandoning the liberalization of corporate governance regimes in the wake of the financial crisis, he concludes, with several large countries instead regressing and moving to more authoritarian or hierarchical systems that are not friendly to minority shareholders.
These backsliders have entered a "vicious cycle," according to Smith, in which poor corporate governance will foster rounds of weakness in both EM economies and currencies.
"The global financial crisis marked the end of the notion that most emerging markets would gradually converge towards U.S./U.K. type liberal governance regimes," he wrote. "The main reason for the very poor performance of some major emerging market economies and markets, most notably Brazil and Russia over the past five years, has been the move to more state directed governance regimes, while China has always been authoritarian despite Beijing’s constant emphasis on liberal reforms."
Corporate governance concerns have long been an unsettling part of the risk/reward calculus when it comes to emerging markets. A potential investment's prospects must be evaluated in the context of the operating environment. For emerging markets, investors are forced to incorporate potential weak shareholder protections, nontraditional ownership structures, higher propensity for corruption, different and sometimes opaque accounting standards, and selective enforcement of the rule of law into their decision-making process.
To use an example provided by Smith, consider the case of large Indian corporations and banks as evidence that in emerging markets the interests of majority owners and minority shareholders are not always aligned. Because of the high degree of family ownership, companies are extremely reluctant to raise money through dilutive equity issuance. As such, these companies turn to the banks for funds more than is necessary. This practice dries up access to credit for economic actors when done en masse, posing an impediment growth.
"The prevalence of family or promoter-controlled companies can however exert a significant cost on the broader economy, in the absence of clear institutional constraints, especially if the boundaries with the state sector are blurred," wrote Smith.
Ownership structure, the analyst notes, does have a visible effect on equity performance. Over the past year, emerging-market companies with state ownership or private concentrated control have underperformed the MSCI emerging-market index, while companies with dispersed ownership have beaten the benchmark:
The analyst points out that investors intent on bargain-hunting in emerging markets have set themselves a tough task, in that it's difficult to find companies that are both cheap and shareholder-friendly.
"[S]tocks and markets which do have better corporate governance characteristics from the perspective of minority investors, stand at big premiums to their peers," concluded Smith. "Investor perception of the quality of governance is clearly the dominant factor in determining asset-based valuation—as many investors have learned the hard way over the past five years, governance is the sine qua non of value investing."
He also warns that minority shareholders could become "collateral damage" as the vicious cycle plays out.
Here's what this sequence would look like. Smith posits that governments, faced with slowing growth and weakening currencies, will use taxes, price controls, or barriers to cutting jobs—which would all crimp margins—to compensate households for their loss of purchasing power in an attempt to maintain their popularity.
Walking down this path is likely to elicit a loss of confidence, capital flight, and a reduction in foreign direct investment, according to Smith, and is self-perpetuating.
"The overall effect is to put further downward pressure on the currency and hence household living standards and to encourage more populist policy-making," he wrote, noting that institutional investors such as sovereign wealth funds would look to dial down their emerging-market holdings if such a sequence did come to pass.
Brazil, Russia, Malaysia, and Turkey appear to have already entered this vicious cycle, he argues, and China may be on the verge of joining them.
These countries are "the most obvious examples of the pernicious linkages between non-liberal governance regimes, economic growth and currency movements," the analyst wrote.
"We should note however that there are no obvious examples anywhere in global emerging markets where governance is moving in a more liberal direction, with the possible exception of Mexico, where the attack on corporate monopolies has come at the cost of margins and hence returns through part of the listed corporate sector, in particular the telcos."