Emerging Markets to face Turbulent and Cloudy Weather in the Near Term

Emerging Markets to face Turbulent and Cloudy Weather in the Near Term  

With the GST being passed after much anticipation, the equity markets failed to impress in the very near term and the expected jump of a couple of percent in the markets did not really happen. In the near term the Emerging markets equities’ long bear market could be over. As of this week, MSCI’s emerging markets index has outperformed its developed markets index over the past 12 months — the first time this has been true for several years.

But that recovery owes much to lackluster developed world growth and recent weakness of the US dollar. After a protracted bear market, a “dead cat bounce” is to be expected. In absolute terms, emerging markets have not recovered at all. As of Tuesday, the EM index was down 2.6 per cent over the previous 12 months. It had not repaid investors. So can EM’s latest revival be trusted?

A look at the sectors and geographies that have prospered suggests caution. The biggest contributors to the MSCI EM over the past year have been Korea (barely an emerging market at all), and Brazil, an intensely speculative destination given its economic problems and political uncertainties. The strongest performer, Peru, has rallied 23 per cent but relies almost entirely on industrial metals.

The two biggest emerging economies, China (down 12.5 per cent) and India (down 4.1 per cent) have registered declines. With India facing resumed uncertainty after the departure of the much respected Raghuram Rajan at the central bank, and China witnessing a fresh turn towards authoritarianism, there are compelling reasons for caution over both. Yes, long-term prospects for the two, as they steadily make up ground with the rest of the world, are strong; their nearer term prospects are cloudier.

At a sectoral level, emerging markets over the past year have relied on materials and information technology, the only sectors to have risen. A resumed decline in metals prices (or oil) would hurt.

Valuations are another concern. The big reason to hunt emerging market assets is yield. In fixed income, there is extra yield to be had. In equities, the rally has gobbled up almost all the opportunity. According to MSCI, emerging market stocks yield 2.65 per cent, versus 2.56 for developed markets. The highest yields come with big political and governance risks, from Russia (4.65 per cent) and Brazil (3.49 per cent). With the hunt for yield looking extreme — witness the flood of US corporate issuance vulnerability to a short-term reversal, especially if the Federal Reserve raises rates next month, looks serious.

Judged by book value multiples, the emerging world is cheap (at a 1.5 multiple, compared with 2.17 for the developed world), but the best value can only be had where there is most risk. Greek equities sell for a 56 per cent discount to book value. Of countries exciting positive commentary for their reforms in recent years, Indonesia trades at 3.09 times book, and India at 3.17 times. At least in the short term, compelling cheapness is not there.

Another reason for short-term caution comes from flows. Money has poured back in to emerging markets this year, largely from European equities. The $34bn that arrived in the past six months cancelled out previous outflows. Investors are no longer significantly underweight.

This is important, because for many investors (US-based), their essential decision will be how to balance their non-US equities between EM and Europe. A good case can be made for Europe, that Europe would be will be more appealing in months to come. More stimulus from the Bank of England and European Central Bank would help and in terms of forward earnings multiples, cuts in European earnings forecasts and the rally in EM have left Germany’s Dax index trading at a premium of only 1 per cent to EM. It tends over history to trade at a premium of 8 per cent.

For the long term, EM looks as appealing as ever, due to long-term growth prospects and valuation. Using the cyclically adjusted earnings multiples, EM trades at 11 times average 10-year earnings, near its low and slightly cheaper than developed markets outside the US (13). The US, at 26, is far more expensive.

Sentiment towards emerging markets tends to move in long waves, so signs that mood is shifting are positive for the long run. But in the short term, EM is vulnerable to a rise in bond yields, or to resumed risk-aversion. This is not the time to make a big top-down asset allocation switch towards emerging markets.

_ Farzan Ghadially