Tuesday, September 25, 2018

Vietnam, an Opportunity Amongst An Emerging Markets Meltdown

Vietnam, an Opportunity Amongst An Emerging Markets Meltdown
By: Michael Molman

            So far 2018 has been shaking up to be a much more interesting year in the financial markets than 2017. Trends that have held for years have suddenly broke amidst a refreshing bout of volatility. This presents investors with an opportunity, if they know where to look. Some of the best opportunities could be found in specific Emerging and Frontier markets. 
Recently Emerging Markets (which were some of the best performers in 2017) have been going through a sharp downturn. The MSCI Emerging Market Equity Index has fallen into a bear market (a drop of over 20%) since hitting a high in January (after being up 32.5% in 2017) while the MSCI EM Currency Index is down 8.5% over the same period. Much of the sell-off is due to a combination of rising U.S interest rates, contagion from economic meltdowns in specific Emerging Markets (namely Venezuela, Argentina and Turkey), and a brewing trade war between the U.S and China. Throw in a rising U.S dollar and a slowing Chinese economy and you get a good old fashioned panic in Emerging Markets. However in the blind dash for the exit, investors are abandoning some markets that are largely healthy. These healthy markets are now trading at much lower valuations then previously, which presents an amazing buying opportunity. Amongst the best looking is Vietnam. 
Chart of iShares MSCI Emerging Markets Equity ETF from 2011 to September 25th 2018. Emerging Market Equities have fallen 20% from their highs.

For many Americans when they think of Vietnam, they picture American helicopters needlessly bombing a jungle or maybe they think of Rambo. In reality though Vietnam is one of the most dynamic developing countries in the world. Over the last 30 years the country has become significantly more attractive to foreign investors eager to take advantage of the country’s young, well-educated population, cheap labor and rapid development. The rapid increase in foreign investment has led to strong economic growth and development. This growth is only expected to continue, PricewaterhouseCoopers (PWC) even estimates that by 2050 Vietnam would be the 20thlargest economy in the world. Not bad for a country that has been a backwater for most of its history. However to fully understand the opportunity the current Emerging Markets panic has created in Vietnam, it is necessary to understand what is driving the country’s economic boom.
Vietnam’s shift from a communist backwater to a Frontier Markets jewel started in the late 1980’s when the country started the transition from a highly centralized planned economy to socialist oriented market based one. The country moved to open up its economy to foreign investors and began to privatize many state owned companies while encouraging small business practices. According to World Bank statistics these reforms (dubbed Doi Moi) helped turn Vietnam from one of the poorest countries in the world to a low middle income nation. To understand just how much Vietnam transformed one must only look at the country’s basic economic numbers. According to the World Bank, in 1985, Vietnam had a GDP of just over $14 billion, the latest data from 2017 shows the country now has a GDP of over $223 billion, that’s an outstanding rate of growth. Meanwhile the country’s population has expanded from 60 million in 1986 to 95 million in 2017 (it is expected to grow to 120 million by 2050), 70% of the population is also younger than 35. Vietnam’s young and growing population is certainly a positive sign for the country’s outlook but it is the nation’s emerging middle class that demonstrates how promising of a market the country can be. Currently 13% of Vietnamese households are considered middle class, but that percentage is expected to increase to 26% by 2026 (some firms including Boston Consultancy estimate that almost 1/3 of the population will be middle class as early as 2020). A large emerging middle class means more disposable income making the Vietnamese market prime for even more growth. Not only is Vietnam’s population is growing in wealth and size it is also relatively better educated then most of it peers. Vietnamese students consistently score high on international tests distributed by the Program for International Student Assessment (PISA). 
Vietnam is also a regional leader in infrastructure investment, with 4.5% of GDP getting invested into roads and other infrastructure, as of now 90% of the country’s population is connected by all-weather roads. Access to household infrastructure has also improved, in 2016 99% of the population had access to lighting, compared to just 14% in 1993. That year, only 36% of the population had access to sanitation facilities and only 17% to clean water, those statistics now stand at 77% and 70% respectively. A large, young, well-educated population and developed infrastructure has made Vietnam a prime destination for new industrial production especially as companies increasingly want to diversify out of China. In 2017 Foreign Direct Investment (FDI) in Vietnam hit a record $17.5 billion. The vast expansion of industrial production and FDI have led to increasing exports, which in turn continues to propel the economy to new heights. 
In 2017 Vietnam’s  GDP increased over 6.8% and growth in 2018 has remained strong, with GDP growing at annualized rate of almost 7% in the 2nd quarter. This represents the strongest 2nd quarter in 11 years and shows the continued resiliency of Vietnam’s manufacturing and exports. The country also continues to attract foreign direct investment, which is 9.2% higher in the first 8 months of the year compared to the same period in 2017. The global ratings agency Moody’s forecasts that Vietnam’s economy will continue to expand at an average annual rate of 6.4% until 2022, and as a result upgraded the country’s external debt on August 10thfrom Ba3 to Ba1 (this link shows Moody’s debt rating scale; Moody's Ratings Scale). Meanwhile the World Bank has upgraded its forecasts for Vietnam’s growth this year to 6.8% from 6.5%, and some analysts, especially from Standard Chartered, are even more bullish believing growth for 2018 could top 7%. The International Monetary Fund (IMF) also decided to chime in on Vietnam’s growth prospects in its first review of the nation’s economy since 2014. In it’s report the IMF proceeded to upgrade its forecasts for GDP growth and praise the government’s  continued efforts to privatize and reduce the size of state owned enterprises. 
Chart showing Vietnam’s GDP from 1985 to 2017. The country’s economy has grown at an annual rate of 5% since 1990.
All the bullish data coming out of Vietnam has not gone unnoticed by investors. The country’s stock market has had 6 straight years of gains, surpassing 6% and surged 48% in 2017 and another 19% in the 1stquarter of 2018. This made Vietnamese stocks some of the hottest in the world as investors bid up prices in the effort to get in on the action. Vietnamese stocks not only benefitted from the strong economic growth but also from reports that Vietnam will be officially classified as an emerging market by MSCI. This would mean inclusion in various broad based Emerging Market ETF’s and increased buying of Vietnamese equities (at the moment Vietnam is classified as a Frontier Market). 
However, market optimism, especially in emerging markets, is often a delicate thing. Developing countries, including Vietnam, have obvious risks that investors are only too eager to highlight when conditions suddenly change. At the moment Emerging Markets are under pressure from a number of different external factors. These factors include the renewed strength in the U.S Dollar, which has rallied over 9% between its low in late February and it most recent high in mid-August. A rising U.S dollar hits countries who have large current account deficits and are reliant on dollar loans for financing. A stronger U.S dollar makes repaying these loans much more expensive and as the dollar rose, countries like Argentina and Turkey, who have large amounts of dollar denominated debt, started to topple. 
At the same time the rising dollar coupled with an economic slowdown in China has depressed the price of commodities. Most commodities are priced in dollars and a more expensive dollar makes commodities more expensive to purchase for none U.S buyers, thereby reducing demand and by extension prices. Meanwhile China is the largest consumer of raw materials in the world so any slowdown in the Chinese economy has outsized effects on the price of raw materials. This is particularly damaging to emerging markets since many developing countries rely on commodities exports to fuel economic growth. 
Another thing hurting sentiment in emerging markets is the tightening of U.S monetary policy. Higher U.S interest rates mean investors no longer have to hunt for high yield in risky developing countries and could instead invest their capital in the relative stability of the U.S. In the decade since the Great Recession Emerging Markets benefitted strongly from the low rate environment. However as interest rates begin to normalize, foreign investors are starting to pull their money from these riskier markets. When you include all these factors and throw in an escalating trade war between the U.S and China, it is easy to see why emerging markets are in the midst of an economic bloodbath.
This recent economic tumult has not spared Vietnam. The country’s stock market plunged over 25% between April and July, while volatility surged to an 8 year high. Declining share values led to margin calls in the heavily leveraged and relatively expensive market, which exasperated the selling. Foreign Investors, who had only months before were consistently buying Vietnamese large caps (foreigners net bought $1.48 billion worth of Vietnamese equities in the first half of the year), started to dump their holdings. This only worsened the sell-off as Vietnam’s top 20 blue chip companies (which were favored by foreign investors) account for 2/3 of the total stock market capitalization, and any large selling in them tends to bring down the rest of the market. For 75% of the days during this period investors pulled money out of the market. Foreigners dumped $70 million worth of Vietnamese stocks in the first half of July alone. 
At first sight dumping Vietnamese assets right now makes sense, especially as the U.S-China trade war intensifies. Vietnam counts both nations as its top trading partners, which means the country may find itself in the middle of a trade war between the 2 largest economies on Earth. As I mentioned earlier, Vietnam has been reliant on exports (as well as FDI) for much of its economic growth. Shipments surged almost 4 fold between 2008 and 2017 and annual exports topped $226 billion in the 12 months ending in March 2018. Trade as a percentage of GDP currently stands at 200% which means any dent in global trade will have negative effects on the country. More concerning is Vietnam’s trade dynamic with China and the United States. 
China is Vietnam’s largest trading partner and the nation relies heavily on its far larger neighbor to the North for raw materials, equipment and capital for its labor intensive manufacturing industry. As such Vietnam runs a huge trade deficit with China, at the same time the United States is Vietnam’s largest export market (you might notice how a lot of your basic goods now say “Made in Vietnam”). As a result Vietnam enjoys a large trade surplus with the United States. This dynamic could mean that the small South East Asian nation may earn itself the ire of U.S President Donald Trump who has vowed to renegotiate trade pacts and reduce America’s trade deficit. Pressuring a small export dependent country like Vietnam with tariffs would not be out of character for the unorthodox President and is a major concern for investors in the small nation. In fact $5 billion worth of Vietnamese exports that are part of Chinese supply chains may already be exposed to U.S tariffs. Vietnam also houses many production hubs for the Chinese manufacturing sector, which only exposes the nation more trade frictions. 
As these risks mount traders are pushing down the value of the Vietnamese currency, the Dong. The currency is loosely pegged to the U.S Dollar and in a bid contain the currency the Vietnamese central bank quietly devalued it by 1.1% this year. If exports start to slip, it is likely the central bank will take more aggressive actions,  which does not bode well for Vietnamese assets. Throw in rising inflation (which in June and July topped the central bank’s target of 4%) and you can understand why investors are fearful of increasing their exposure to Vietnam. However, it is possible that these risks are overstated and that the recent sell off in Vietnamese equities actually presents a long term opportunity. 
Chart showing Vietnam’s dependency on exports. As you can see Vietnam is much more dependent on exports then its other South East Asian peers. This exposes the Country to trade friction.
          To understand this opportunity investors have to look deeper into the factors behind the recent sell-off. Let’s start with the elephant in the room, the main driver behind the recent flight from Vietnam, the rapidly escalating trade war between the U.S and China. Any trade war, inevitably causes collateral damage, not just to the intended target but to the many players involved in the various sprawling supply chains. However, in this case, a trade war between the U.S and China might be accelerating a trend that has been benefitting Vietnam and other South East Asian countries. This trend is the shift of the manufacturing and industrial bases away from China. As wages at Chinese factories continue to rise, multi-national corporations are increasingly moving out in search of cheaper labor. With Chinese made goods now the target of U.S tariffs, companies have all the more incentive to move away from the country. 
Vietnam is a natural place for companies to set up their new Asian production centers. According to VinaCapital (one of Vietnam’s largest asset managers) Vietnamese laborers are 66% cheaper and just as productive as their Chinese counterparts. This coupled with the nation’s relatively well educated, young population and a rapidly developing infrastructure, make Vietnam an attractive destination for new industrial investment. Multiple companies have already moved their production to the country. One of the larger ones has been Samsung, which has invested $17 billion in Vietnam and now uses the country as its main manufacturing hub for its best-selling smart phones. Clothing companies are also shifting their manufacturing, the U.S Fashion Industry Association released a study in July which shows that 2/3 of all textile companies are expecting to lower their production in China. Some of these companies, like Adidas, have already moved to Vietnam (Adidas now manufactures twice as many shoes in Vietnam as it does in China). As the production processes continue to flee China in favor of South East Asia, it makes sense that Vietnamese manufacturers continue to see new growth. In August the Nikkei Vietnam Manufacturing Purchasing Managers Index (which measures manufacturing activity in the country) recorded in 33rdstraight month of increases.
In fact, despite the massive broad based pull back from Emerging Market, cashflow from other Asian countries into Vietnam is still trending up. Properties in the country are priced at a significant discount, compared to those in neighboring Singapore and Thailand, and properties in Ho Chi Minh City are 1/10ththe price of similar properties in Hong Kong. This makes Vietnam one of the best real estate plays in Asia and gives the country a strong advantage over other South East Asian countries viewing to attract industrial investment.  So even as investors fear that a trade war could dent Vietnamese exports and hurt the country’s stellar growth, it is actually attracting greater FDI and is expanding the nation’s industrial and manufacturing base. 
The other risks that have weighed on Vietnamese markets may also be exaggerated. Let’s take the higher dollar and rising interest rates for example. As was mentioned before, these things hurt nations with large amounts of dollar denominated debt and who run current account deficits. Vietnam is not Argentina or Turkey, although the country maintains an uncomfortably high debt to GDP level (which is at 61.5%) the government has taken concrete steps to solidify the nations finances. These steps, which include deficit reduction and divestment of state owned enterprises, are expected to contain public debt. About ½ of Vietnam’s external debt is financed through favorable terms with large multilateral institutions, like the World Bank, IMF and the Japan International Cooperative Agency. This is in stark contrast to other Emerging Market countries who have financed there growth primarily with bank loans.
 The Vietnamese government has also restricted lending to less productive industries and has been forcing banks to reduce their bad debt (the bad debt ratio for the Vietnamese banking industry fell to 2.09% in late June compared to 2.46% in late December of 2016). In addition to these actions the Government has moved to modify the country’s debt structure in order to reduce reliance on foreign denominated loans (something that has sunk the economies of Argentina and Turkey). According to Moody’s this has made the Vietnamese economy less vulnerable to external shocks, which incidentally explains why Vietnam’s credit rating is being upgraded even as fears of default rise in other Emerging Markets. Meanwhile, the country’s strong exports mean the nation runs a steady current account surplus which only reduces the need for foreign debt. Throw in robust growth in personal consumption caused by rising household incomes and expansion of private credit and it is hard to be concerned about Vietnam’s growth and finances.
Concerns over rising inflation and the falling Dong also seem to be overplayed as well. Although fears of inflation increased over the summer (inflation in June and July was 4.67% and 4.46% respectively) as the Dong sold off, there are signs that prices and the currency are stabilizing. The State Bank of Vietnam and a survey of economists conducted by Focus Economics expect annual inflation to run below 4% (which is the Central Bank’s target) in 2018. The country has also been steadily increasing its foreign exchange reserves, which it could use to prop up the Dong if necessary. In March the nation’s FX reserves stood at 25.7% of GDP compared to 21.75% in December of 2017. However as the dollar begins to stabilize, following its recent surge and Vietnam’s strong growth continues, it is unlikely that the Dong will depreciate further. Despite the devaluation of its currency, the Vietnam’s central bank has done a good job keeping the Dong pegged to the dollar. The state bank has ensured that the Dong does not shed more than 3% against the U.S dollar annually. This explains why Vietnam’s currency is only down just over 1% against the greenback while other South East Asian countries like Indonesia have seen their currency plummet as much as 10%. So when you consider the fact that FDI is expected to continue increasing, the decreasing dependency of foreign denominated debt, stabilizing currency and contained inflation, it is easy to see the recent sell-off in Vietnamese assets as an opportunity. 
Chart showing Vietnam’s Current Account from 2013 to 2018. The country has run relatively consistent current account surpluses which makes the country less vulnerable to external shocks.
Chart showing Vietnamese FX reserves from 2008 to 2017. The country has been building up its reserves which allows it to prop up its currency. 
           It has become clear that investors have been trading emerging markets as a block with little regard for the fundamentals of specific markets. This presents an opportunity to dive back into emerging markets that have proven to be more resilient to the turbulence, markets such as Vietnam. Even as Vietnamese shares sold off in the face of foreign liquidations, earnings have continued to grow at a historic rate. This means earnings multiples for Vietnamese stocks are at the lowest level they have been in a very long time, giving investors a perfect entry point into the market. 
            Prior to the Emerging Markets sell-off, some analysts were concerned that Vietnamese large caps had gotten too expensive. This is understandable given that at the top of the market in March, Vietnamese stocks traded at an average P/E of over 20x, a much higher multiple than other emerging markets. However, following the recent market sell-off that multiple has fallen to around 16x, and if you do not include the top 5 listed companies, the average P/E for Vietnam’s main Ho Chi Minh index is about 14.5x. This puts Vietnam’s equity valuations just about in line with other South East Asian countries and 21.32% below their own historical averages. Additionally, but when you compare Vietnam’s equity valuations to GDP growth, it becomes obvious that Vietnamese stocks present much better value than stocks in other comparable nations. For example, Vietnam’s GDP growth in 2018 is expected to be around 6.5%, and as mentioned before, it’s main equity index has a P/E of around 16x. The Philippines has a higher expected GDP growth of 6.8% but on average its equities trade at a high P/E of 19x. Thailand, meanwhile, has equities trading around 15x forward earnings but has a much lower GDP growth of 4.5%. Other South East Asian countries, the Philippines and Indonesia specifically, have also been running consistent current account deficits and have been gorging on dollar loans. This makes them vulnerable to the same external shocks that sent Argentina’s and Turkey’s economies reeling. Throw in the added political instability (yes Philippines I am talking about you) and you can understand why Vietnamese stocks trading at the same valuations as equities in its neighboring countries presents an opportunity. 
            This dynamic could explain why Vietnam fared better in the current situation then its neighbors and why, despite the broad sell-off in emerging markets, foreign investors still net bought Vietnamese equities this year. According to Dragon Capital, foreign investors withdrew $5.6 billion from the Thai market this year through August, $3.7 billion from Indonesia and $1.6 billion from the Philippines. Meanwhile foreign investors net bought $1.8 billion worth of Vietnamese stocks. Vietnam’s general statistics office views these capital flows as a positive sign, despite the increased volatility in the country’s financial markets. Some Vietnamese based funds, including Dragon Capital and VNDirect Securities, have echoed this sentiment. With every industry reporting earnings growth in excess of 20% year over year through the end of the 1stquarter, and with equities trading at these valuations it’s hard not to be excited about Vietnamese stocks. 
Chart showing Vietnam’s main VN stock index from 2016 to September 25th2018. The index soared 48% in 2017 before falling over 25% between April and July. It is currently up 13% from its lows.
           Vietnamese stocks look relatively cheap to their historical averages, earnings and international peers. When you consider the country’s macroeconomic stability and growth it is easy to see why Vietnamese equities have rallied 13% since hitting their lows in July. Unfortunately, it is difficult for retail investors to get in on the action since it is virtually impossible to invest directly in individual Vietnamese stocks. Luckily, there are a number of liquid ETF’s out there that allow small investors to gain exposure to the country. 
            The most popular one is the VanEck Vectors Vietnam ETF (VNM). This U.S traded ETF is probably the most pure way for investors to gain exposure to Vietnam. The ETF has total assets of about $278 million and is composed of companies that are incorporated in Vietnam, generate half their income in Vietnam, or have half their assets in the country. The funds main objective is to track the MVIS Vietnam index and managers invest at least 80% of the fund’s assets in securities of the underlying index. Another option for interested investors is the VinaCapital Vietnam Opportunity Fund (LSE: VOF). This fund trades on the London Stock Exchange and is a closed ended investment company aiming to achieve medium to long term returns in Vietnamese assets. The company mainly invests in Vietnam focused listed and unlisted companies, debt instruments, private equity, real estate and other opportunities. Given that the fund trades at a 18.9% discount to its net asset value, it gives investors a cheap way to gain access to a more actively managed Vietnamese investment portfolio. 
            Of course there are many risks in investing in Vietnam or any developing country for that matter. The country’s financial markets are considerably more volatile, prone to wild swings and asset bubbles. However, for investors willing to take on the additional risk, Vietnam offers an amazing macro based opportunity. The Vietnamese government continues to push for the privatization of state owned companies and is planning on loosening regulations to make it easier to start businesses and invest in the country. According to Deloitte, the government’s continued actions to open up the economy and encourage foreign investment will keep the Vietnamese market attractive for at least the next 5-10 years. With valuations in the country depressed following the sell-off in Emerging Markets, investors have a rare opportunity to gain cheap exposure to one of the most impressive developing countries in the world, just as it begins to realize its potential. 

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Disclaimer: This material has been written for informational purposes only, it should not be considered as investment advice. Any investment decision should be made after consulting multiple sources and a financial advisor.