Much has been made of the recent pullback in emerging markets, and with good reason. Many of the regions that powered global growth through the Great Recession with great gusto have struggled to make headway amidst a host of issues, while the US economic engine revs up after a long stall. Currency issues, solid long-term fundamentals, elevated corporate debt levels in emerging economies, and US corporations looking to deploy massive cash hoards all point to an incoming period of increasing M&A activity in emerging markets.
First, the most obvious argument – a stronger US dollar. Without a doubt, the US dollar has appreciated in the past 18 months against a basket of international currencies to levels not seen in over a decade (Fig 1).
As the most crowded trade in the currency markets for 2015, the reasons behind the strength of the US Dollar have been beaten to death, so I won’t go into great detail here. Suffice to say, US economic strength and divergent monetary policies have made for a double-whammy against EM currencies, and that’s ignoring the effects of a downturn in commodity prices. All this makes the acquisition of EM companies by American ones all the more appetizing, as they have been effectively reduced in price by 25% right off the bat – over 45% in the case of Brazil, where the BRL has been walloped in the past 12 months.
It’s not all bad news in EM countries, however. During the boom years, many invested heavily in infrastructure projects, from industrial spending on transportation and utilities to social spending on healthcare and education. In fact, according to a PWC report from mid-2014, spending among Emerging And Growth Leading Economies (EAGLEs – defined in this article as Brazil, China, India, Indonesia, Mexico, Russia, and Turkey) on infrastructure projects grew by anywhere from 25% to over 50% from 2008 through 2012. While the forecasts of that report have undoubtedly needed revision since its publication, the previous investments are already in place, serving to increase the productivity of workers in the EAGLE countries.
The other half of the real GDP growth equation, population growth, is also very promising. As seen in Figure 2, these countries are expected to add an extra 160 million people in them between 2013 and 2018 – the equivalent of adding an extra 50% of the population of the United States. While the EAGLEs’ productivity lags behind the US by nearly a factor of 8, their massive populations will greatly magnify the productivity gains from this infrastructure spending in absolute terms. This presents a great opportunity for healthy corporations to expand in these markets, leveraging existing infrastructure, both public and private, to take a slice of this quickly growing pie.
During the years of high growth on which the rosier PWC forecasts were based, the corporations of EM countries went on something of a credit binge. According to the IMF, between 2004 and 2014, corporate debt of non-financial firms was up by 350%, growing from $4 trillion to $18 trillion (USD), and was up 26 percentage points relative to GDP in this period. While the most egregious of this credit binge has been China (Figure 3), with non-financial corporate debt reaching a whopping 198.2% of GDP by Q1 2015 , up from 129% at the start of 2004, there has been a stark increase in debt among the rest of the EAGLE countries, as well, both in absolute and relative terms (Figure 4).
Something of note in these increased debt-loads is that bonds accounted for only 9% of debt in EM countries in 2004. By the end of 2014, this amount had increased to 17% , totaling nearly $1 trillion USD, partially a result of record low interest rates set by central banks trying to keep a lid on currency appreciation. The IMF’s Global Financial Stability Report also found that higher leverage among non-financial EM corporations tends to coincide with rising foreign currency exposures for those firms, meaning the firms with the most debt were more likely to have issued it in foreign currencies – predominantly in US dollars. With the sharp appreciation of the USD, this is becoming a burden for many of these firms. Unlike bank loans, the terms of bonds are extremely difficult to renegotiate, virtually setting them in stone. Senior debtholders can pressure companies to spin off business lines to generate cash (a potential opportunity for acquisitions unto itself) to protect their investment. Depending on the jurisdiction in which the bonds were issued, they may even be governed by US law, which can be far more amenable to protecting debtholder rights than many EM countries’ equivalents. Companies doing business in US dollars now not only have the opportunity to purchase businesses in Emerging Markets at a discount due to currency movements, but can assume the company’s debt at a steep discount, as well, while inverting their targets’ currency-risk profiles into far more favorable ones.
Record corporate cash piles in the developed world are the final piece of this puzzle, as in the US, which has been hoarding massive stockpiles of cash. In fact, Moody’s estimates cash holdings have reached $1.73 trillion USD in American corporate bank accounts – and shareholders are mounting pressure for it to be utilized. Much of it is held outside of the US for tax reasons, however, so many of these companies are issuing bonds domestically and using the proceeds to return cash to the shareholders through share buy-backs. This is a less than ideal way for this cash to be used. For one, the Federal Reserve is poised to raise rates imminently, making this strategy more expensive in years to come. Secondly, many shareholders are beginning to raise concerns about juicing stock returns through financial engineering practices such as buybacks compared with investing it for long term returns. Steep discounts on companies in EM countries are a tempting target for all this cash and a solid company undergoing temporary distress would be an excellent way to both appease shareholders while smartly exploiting a host of favorable factors to ensure long-term growth for years to come.
The negativity surrounding any discussion pertaining to the state of emerging market economies is rooted in legitimate concerns. However, as the numbers show, opportunities abound to make long-term investments in regions that will surely be among tomorrow’s economic powerhouses.