- Despite continuing headlines of concern, EM markets have rebounded recently.
- In order to sustain that rally, we need to see progress on export volumes and political/economic reforms.
- While not universally cheap, EM equity valuations are not unreasonable and we continue to find bottom-up opportunities.
A month ago, much of the news from the emerging markets (EM) was negative. We saw headlines highlighting the liquidity headwinds created by U.S. QE tapering, Russia’s aggressive opportunism in the Ukraine, China’s imminent hard landing, Brazil’s drought leading to an imminent energy crisis, a state of emergency being declared in Thailand, Turkey’s political soap opera continuing with business and political leaders being arrested on corruption charges, serious devaluation of currencies in Venezuela and Argentina, and let us not forget the “fragile five” (Indonesia, India, Turkey, Brazil and South Africa) and the ongoing concerns surrounding their current and fiscal accounts. In all, there is clearly no shortage of issues to worry about. In fact, from October 2010 through February 2014, those sorts of concerns have played an important part in causing emerging markets to underperform their developed counterparts by approximately 40% in a very consistent manner.
However, we have seen a notable market shift recently. Since the lows in early February, the EM index has risen by 11%. Emerging market equity fund flows (which had been negative for a record 22 consecutive weeks) turned positive last week. This has been driven primarily by a reduction in the risk premium, triggered by a number of factors. Fears surrounding the fragile five were overextended at the end of the year. Currency weakness and higher rates in those markets have led to a certain amount of natural adjustment in the current and trade accounts, and suddenly they do not appear quite as vulnerable as they were perceived just a short time ago. In fact, the fragile five are among the top performing markets in the EM universe (and the world) this year in $ terms — India +7.69%, Indonesia +27.98%, Brazil +7.9%, South Africa +5.82% and Turkey +14,53%. We recently noted that election cycles can create opportunities amidst pervasive pessimism as newly elected governments normally have a window to push through much needed reform. Polls in India, Indonesia and Brazil have shown pro-reform candidates (or in Brazil’s case anyone but the incumbent) gaining steam and have acted as a catalyst for these markets. In China we have seen an announcement of a mini stimulus as well as some SOE reform (Sinopec’s announcing the sale of its marketing division). As for Russia, things have not escalated further for now but we remain very cognizant of tail risk in this market. While there are still plenty of risks, we see directional and aggregate improvement in the overall risk environment.
So the question is, is it time for emerging markets to start to outperform again on a more sustained basis? Unfortunately, the answer is not so easy. The EM universe faces major challenges. QE tapering will continue and accelerate over time which is a clear, if well recognized, headwind. China still has the issue of rampant overcapacity and legitimate concerns about major credit excesses. Even with thoughtful reforms and demonstrated will from the well-resourced central government to combat these issues, they will take time to work through the system. The commodity super cycle of last decade is over — which will benefit some commodity importing countries but also hurt some of the large commodity exporters. Brazilian elections are still a ways off, so perhaps the market is getting excited a little too early about the prospects of change. With reservoir levels running at historic lows, the country will very likely face energy rationing, which may push the economy into a technical recession. Finally, valuations are not as cheap as they might first appear at 10x earnings and 1.5x book value. If you take a closer look at the index constituents and exclude the Chinese banking and Russian energy sectors which trade in the low single digits P/E’s, the rest of the universe does not appear so strikingly cheap. There are good stocks to buy at reasonable valuations, but it is not the “close your eyes and buy the EM universe” cheap that it might appear to be at first glance.
In order for this to be a sustained rally, we need a real pickup in exports and/or real reform momentum. For most EM countries, exports remain the most important factor in explaining long-term growth. Strong exports not only help export-oriented companies but also boost domestic consumption as exports trickle down through the economy. EM exports peaked in late 2010 and have stagnated at or below zero in recent quarters. The developed world (the core of the export consumer market) is recovering, but it has been an anemic recovery. U.S. growth has not broken out of the 2%-3% range, the eurozone is no longer contracting but expectations are for growth of only about 1%, and there are questions regarding Japan’s ability to sustain any growth rebound with the introduction of the new consumption tax. So EM growth hinges partly on a sustained global pickup which is yet to materialize. The other big catalyst for sustained outperformance is reforms. China is in the spotlight on reform issues as the world watches to assess the implementation path for the impressive change agenda announced last fall. Some important concepts were raised, but now it is a matter of will and execution. Elections in Brazil, India, Indonesia, Turkey, South Africa and Thailand provide hope that true reform windows could be opened and confirming evidence of improved governance would be cheered by the market.
In closing, it is important to emphasize that on the micro level we are finding opportunities within countries and within specific industries. The emerging markets are a diverse and broad universe that is often painted with a very broad brush for short periods of time. Given the strong macro crosswinds buffeting the emerging world, we believe differentiation among GEM countries, sectors and stocks will matter more than ever.