Marginal bet

An intriguing comparison between economic growth potential and valuation of stocks comes from Deutsche Bank this morning. When looking to invest globally, it is a good idea to track economic growth potential, right? And that means looking hard at emerging markets, doesn’t it? Well, not necessarily. The overall growth of the economy does not necessarily mean that the public companies within that economy are souind investments. Plus, with globalisation, cross border economic activity, companies domiciled in one country can readily benefit from economic growth in another. For Australian investors there is also the currency play, profiting from what is probably an overly strong currency by investing offshore and wiating for the currency to weaken. But simply targetting where the emerging market growth is too simplistic.

The Deutsche report says margins in Latin America and EM Europe are at 14.4% and 15.3%, respectively, benefitting greatly from the oil and commodity boom. On the other hand, in Japan net income margins are 3.3%. In the middle, margins in Asia ex Japan (8.8%) are higher than that of the US (8.4%) and Europe (7.3%). But it is the growth that matters:

Corporate profit margins are at or near peak levels across all regions andthere is growing concern they will fall and drag down earnings growth. But not all margins, and therefore risks, are created equal. Regions and sectors are dealing with very different dynamics that will drive profitability. Here DB’s team of Equity Strategists across the globe present their frameworks for analysing margins, representing a comprehensive and unique cross-section of approaches as background to their views on prospects for margins and earnings.

We think developed market (“DM”) margins are more sustainable than investors believe. Our main conclusion is that DM margins should be well supported in this cycle, with risks to the upside. In the US, pricing power is rising, labor costs are trailing and top line growth is providing operating leverage, while commodity cost growth appears to be moderating. In Europe, operational leverage on the back of global GDP growth and spare capacity should boost margins. Low margins in Japan provide a high beta play on the global cycle and reconstruction.

However, margins in emerging markets (“EM”) are likely to disappoint. Despite the huge growth advantage, EM ex-Financial margins are actually 400bps lower than they were in 2005 as a result of tremendous increases in capex and operating expenditures. EM Financial margins, on the other hand, have increased massively on the back of top-line growth. EM corporates will likely not have above trend EM and global growth in this cycle to prop up margins, leaving them even more exposed to the structural drivers that will continue to weigh on margins including: overinvestment, rising wages/costs, demographics, state intervention and increased competition.

Continue to overweight DM over EM. A valuation cushion in DM suggests that the market remains skeptical of the upside potential in DM margins, particularly in the US. On the other hand, unless asset turnover in EM continues to soar and compensate for weak margins, earnings growth will likely disappoint investors; EM stocks should continue to underperform as the market has limited tolerance for surprises. Finally, given the magnitude and duration of the EM upcycle coupled with the high level of investment, we are keenly aware of the implications of a “hard landing” anywhere in EM and position accordingly.

To return to my hobby horse, deep questions remain in emerging markets about their adherence to the discipline of the cost of capital. Not that developed markets are in good shape, with their cheap money: negligible interest rates and initiatives like quantitative easing. But emerging markets can be perilous, for a number of reasons.

Which is why, one might add, the $A is so high. It is a proxy play on China’s when you can’t, or wouldn’t want to, invest into China.

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