Can Defensive Stocks Defend Themselves Against The Stir In Emerging Markets?

Many firms of late have been targeting the emerging world to achieve growth, and until very recently, this strategy was very well justified. With GDP growing at a double digit rate in countries across Asia, Africa, and Latin America, sales flourished for many companies. This is particularly true for names such as Philip Morris International (NYSE:PM) and Diageo (NYSE:DEO). At a time when rising health awareness and regulatory crackdown surrounding the sale of products such as alcohol and tobacco tightens in developed markets across North America and Europe, these companies have increasingly diversified operations across developing markets, where economic growth, slacker regulation, and a growing middle class population has been driving sales. More recently however, the developing world has been facing problems, against which the phenomenal growth it was otherwise achieving has been hampered. What could this development mean for conglomerates such as Philip Morris and Diageo? Is this the turning point for these stocks or will there be a rebound?

Source: World Bank

Let’s start by backing up a bit. The global financial meltdown back in 2008 was predominantly a crisis that started from the developed world, involving American and European banks. Even as contagion spread across different parts of the world, large emerging economies such as China and India recovered rather quickly and became the engines for global growth in the ensuing years. Many economists spoke of how these countries, along with others such as Brazil, Russia, Turkey, Indonesia, Nigeria, and Mexico could be the future of the world economy. And this seemed to pretty much actualize until recently.

Historically, most countries have driven growth through exports. But this works only if exports can find a market, which has, for the most part, been China. More recently, the Chinese economy has experienced a slowdown. The result — a number of markets that supplied China with components, finished goods, fuel, and raw materials have faced a slump. The Chinese economic slowdown was also a major contributor to declining oil prices. The result — a recession in a number of oil exporting countries such as Russia and Venezuela. One might argue that cheaper oil should ideally not have such a major consequence on world economic growth since turmoil in oil exporting countries could be offset by higher purchasing power for consumers in oil importing countries. But this release of disposable income has hardly resulted in higher spending activity.

To make matters worse, China is attempting to revive its exports after a report in June suggested an 8.3% decline. They are doing this predominantly by devaluing the Chinese yuan to increase the price competitiveness of their goods in the global market. Is there more to come? The answer lies in China’s August numbers that showed the fastest decline in manufacturing witnessed in more than six years. ^[1] This could spell further depreciation of the yuan going forward. What could the impact be? For one, a depreciating yuan could trigger some sort of a currency war, where other countries also peg their currencies at lower levels to stay afloat in the exports market. This has already started, with names such as Azerbaijan, Georgia, Kazakhstan, and Vietnam devaluing their currencies over the past year. ((Double Devaluations Roil Emerging Markets As Dong, Tenge Tumble)) Moreover, these developments have sent financial markets into a tailspin, with leading indices such as the Dow Jones, FTSE 100, and S&P 500 declining approximately 10% since August 17.

Now, what impact could this have on conglomerates such as Philip Morris and Diageo, who have been banking on the emerging market phenomenon to fuel growth?

1 — Slower economic growth could immediately translate into slower growth of purchasing power of people and a slower expansion of the vital middle class population. Given that the demand for alcohol and cigarettes tends to be relatively acyclical, in that they are slower to respond to business cycle fluctuations, Diageo and Philip Morris could breathe a sigh of relief. In spite of this, although these names may not lose out significantly in terms of volumes, they may lose out on revenues as new customers choose brands in the economy category and existing customers down-trade to less premium options.

2 — Devaluation of a number of key emerging market currencies vis-a-vis the dollar is bound to exert an adverse impact on the company’s financials. While on the one hand a devalued currency discourages demand by making international offerings more expensive in the domestic currency, money made in the domestic market could translate into fewer dollars to negatively impact the company’s income statement.

3 — Third, while Diageo and Philip Morris have resorted to price hikes to maintain revenues in developed markets, this option may not be viable in emerging markets. This is because demand in these markets are more sensitive to price changes. According to one study, while the price elasticity of demand for cigarettes is estimated to be 4% in developed markets, it is estimated at 8% in developing markets, i.e. a 10% increase in price could lead to an 8% decline in demand. ^[2] At these rates, price hikes may only exacerbate the declining volumes to pull revenues even lower.

Now, would the current events send emerging economies spiraling downwards? Clearly, the world economy is in a turmoil at present and history is repeating itself — where a Chinese devaluation is leading to a wave of devaluations, just as the Federal Reserve prepares to tighten monetary policy with rate hikes. Twenty one years back, these very steps resulted in the Asian financial crisis. However, things may be different this time. For one, even as a number of Asian and Eastern European countries follow through with devaluations, this time simply may be different since Asian economies are better cushioned in terms of their fiscal positions and currency reserves to weather the storm. Furthermore, given the exposure to a number of crises, including the massive crisis in 2008, most countries may be better prepared to deal with such situations. Second, there may be a limit up to which China would be willing to devalue its currency since it could, in fact, harm its own economy. According to Nomura, total Chinese external liabilities are estimated at $1.135 trillion. In this case, repaying dollar denominated borrowings will not only become increasingly expensive, but would also curtail future borrowing capability for Chinese companies. Clearly, when the motive behind the devaluation is to stimulate the economy, China may not pursue this policy beyond a point if it is, in fact, defeating the purpose.

For now, stocks such as Diageo and Philip Morris are called “defensive stocks,” in that they are stable even during economic contractions. However, only time will tell if they will actually be able to defend themselves against this stir in the emerging world. While we anticipate some currency related losses in the short to medium term, the companies could see growth in the longer term backed by innovations and strong business fundamentals.

Trefis has a $115 price estimate for Diageo, which is above the current market price.

See Our Complete Analysis For Diageo Here

We have a price estimate for Philip Morris’ stock price of around $82, which is almost in line with the current market price.

See Our Complete Analysis For Philip Morris International

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1. Global stocks in ‘panic mode’ as Chinese factory slump drags on markets [↩]
2. Price elasticity of demand for tobacco products [↩]