Reforms driven by pressure from the growing middle classes are a major emerging theme for emerging markets in 2014, according to GAM's Matt Linsey, manager of the GAM Star North of South EM Equity fund.
Dramatic elections held in a number of key markets are one manifestation of that pressure, although Mr Linsey argues it is important to differentiate the potential impact on the individual equity markets that constitute the region.
In India the unprecedented victory of Narendra Modi has transformative potential for the country, the economy and the stock market because a reform-oriented government with a strong mandate may resolve many of India’s self-inflicted problems.
By cutting fuel subsidies, the country will resolve its deficit problems while returning profitability and growth to its energy companies, Mr Linsey suggests. By cutting red tape, "much needed" investment in infrastructure can resume. State controlled enterprises will be run professionally, aiming for profit and growth rather than satisfying political objectives, he predicts. With sensible policies, the high cost of capital should fall. The profitability of India’s corporate sector should increase dramatically as a result, more than justifying the current market rally.
There was also a reformist presidential election victory in Indonesia. However, Jokowi’s win was by a narrower margin than expected and his opponent Prabowo is challenging the result. Prabowo also controls Parliament and can effectively block reforms that the markets are expecting.
"Unlike in India, there is little state interference in the corporate sector and most companies are already well-run and profitable. It is harder to justify the market’s high valuation in this situation, as risks remain substantial and the scope to improve corporate profitability is more limited," GAM argued.
The next significant election will be in Brazil, where President Dilma’s economic policies and interference in state-run companies have resulted in a collapse in economic growth and the profitability of state-controlled businesses. Like India, many of these problems are self-inflicted and could be resolved by a determined opposition candidate like Aecio Neves.
His election could result in a sharp drop in the cost of capital and a major re-rating of companies such as Petrobras, which are being destroyed by current policies, according to Mr Linsey. However, it is not yet obvious whether the opposition will win. Despite a widespread middle-class revolt against Dilma, her status as the successor of President Lula still gives her significant support among Brazil’s poor.
China, although it does not hold elections, is a crucial play on the reform theme. A new leadership introduced last year is under tremendous pressure to end corruption and waste, while rebalancing the economy.
State-owned enterprises (SOEs), which make up 75 percent of the Chinese stock market, are at the forefront of this clean-up. Hundreds of managers and officials have already gone to prison and there is a real drive to reduce corruption at all levels. This has the potential to both improve profitability and valuations of SOEs, as well as levelling the playing field for the private enterprises that compete against them. Valuations in the Chinese market remain very low after years of underperformance. Although there is no election trigger, there is significant upside for many stocks if the anti-corruption drive continues, Mr Linsey concludes.