Emerging Market Rout Spells Opportunity
The investor love affair with emerging markets is quickly fading. For much of the past decade, emerging markets - Asia being the largest - were the place to be, offering explosive growth compared to the meagre offerings of the developed world. The trend spawned sexy acronyms such as BRICs, numerous indices to try to capture the growth and, of course, dedicated emerging market equity and bond funds which attracted billions of dollars. But like many a love affair, this one too has now soured, with the stocks, bonds and currencies of emerging markets significantly underperforming those in much of the developed world this year. There are a host of reasons for the underperformance, such as fears about the U.S. reducing quantitative easing (QE), much of which has leaked into emerging market asset prices, the fall in commodity prices hurting growth and the unwinding of a credit bubble in China.
The investor love affair with emerging markets is quickly fading. For much of the past decade, emerging markets - Asia being the largest - were the place to be, offering explosive growth compared to the meagre offerings of the developed world. The trend spawned sexy acronyms such as BRICs, numerous indices to try to capture the growth and, of course, dedicated emerging market equity and bond funds which attracted billions of dollars.
But like many a love affair, this one too has now soured, with the stocks, bonds and currencies of emerging markets significantly underperforming those in much of the developed world this year. There are a host of reasons for the underperformance, such as fears about the U.S. reducing quantitative easing (QE), much of which has leaked into emerging market asset prices, the fall in commodity prices hurting growth and the unwinding of a credit bubble in China.
Asia Confidential thinks that some of these reasons will prove overblown and it offers long-term investors the opportunity to soon pick up stocks in countries with still strong growth prospects, principally in Asia. Not all emerging markets are alike though and you should avoid those which are reliant on commodities and/or exports. The focus instead should be on those countries with the best domestic consumption stories. On that basis, India and Thailand are our top picks.
Emerging markets pummelled
Emerging markets have become the ugly ducklings of the financial world. This year, the MSCI emerging market index has fallen 4% in U.S. dollar terms, compared with a 14% rise in the S&P 500 and 5% increase in MSCI Europe. Latin America has been the main culprit dropping 10% while Asia ex-Japan has declined 2%.
In Asia, the larger index weights in China and South Korea have dragged on performance, down 6% and 7% in U.S. dollar terms year to date. Notably though, the world's best performing region since the crisis, South East Asia, has also started to turn around. Market darlings, Thailand and the Philippines have been hardest hit, falling 8% and 12% in dollar terms over the past month, though they are still up 1% and 9% respectively this year.
The currency falls in emerging markets have been even more severe. For instance, the South African rand has declined more than 18% this year, even outdoing the 16% drop in the Japanese yen. The Argentine peso and Brazilian real have also decreased 8% and 4% against the dollar respectively. The only bright spots have been the Chinese yuan and Mexican peso, up 2% and 1% respectively.
Emerging market fund flows confirm that investors are heading for the exits. Emerging market equity funds had net redemptions of US$3bn in May, the highest since end-2011. Global emerging market funds were the worst hit, with outflows of US$1.4 billion followed by Asia ex-Japan at US$872 million, EMEA (Europe, Middle East & Africa) funds at US$324 million and Latin America at US$303 million.
Emerging market bond fund flows have also turned negative amid heightened volatility. For the week ending May 29, fund outflows totalled US$143 million, the first weekly outflow since August 2012.
Reasons for the fall
There are a host of reasons behind the sharp downturn in emerging markets, including:
1) Fears over the U.S. cutting back QE. Much of the printed money since 2009 has leaked into areas offering growth, particularly emerging markets. If the speculation about so-called QE tapering is right, that supply of printed money could soon dry up.
2) Concerns over rising bond yields. Talk of QE tapering has lifted U.S. bond yields and have put upward pressure on emerging market bond yields as a consequence.
3) Continued weakness in commodity prices. That weakness of course impacts commodity-producing nations such as Brazil, Mexico, South Africa and Indonesia. For instance, sugar prices have declined close to 30% since last July, which has an obvious effect on the world's largest sugar producer, Brazil. The rout in gold prices has impacted South Africa, though it has a host of other economic issues it's also dealing with.
4) Weakness in other previously strong growth markets. Notably China, where GDP growth has slowed from the 11% of the past decade to under 8% as a credit bubble unravels. Also India, where economic growth is the slowest in a decade as investment slows while inflation remains a risk, thereby limiting scope for further rate easing.
5) Perceptions of increased political risks haven't helped. We're primarily referring to Turkey, where there've been major protests against the government's alleged authoritarian ways and attempts to impose Islamic conservative values on a secular state.
EM story far from done
There are good reasons to believe though that a number of the factors behind the emerging market underperformance will prove unfounded, or at least, exaggerated. For example, concerns over potential QE tapering are likely to be a massive head fake.
The primary factor making QE tapering highly unlikely is that deflation remains the central threat to developed markets, including America. US headline CPI inflation has slowed from 3.9% in September 2011 to 1.1%. That means real interest rates are rising, which is inherently deflationary.
Second, money velocity at 60-year lows in the U.S. also signals deflation is the principal risk. After all, money needs to change hands and filter through to the economy for QE to work. That's not happening right now and it's why U.S. growth remains remarkably weak post the financial crisis.
These strong deflationary trends make QE tapering improbable. And if the Federal Reserve does decide to cut stimulus, it's likely to reverse course quicker than Ben Bernanke can retreat from office to hand Janet Yellen the mess that he's created!
There are other factors that are supportive of many emerging markets outperforming their developed market counterparts from here. I say "many" emerging markets because lumping them together is silly and unhelpful. The popular slogan, the BRIC (Brazil, Russia, India & China) economies, was always just a slogan because Brazil and Russia had unsustainable growth models which were over-reliant on commodities.
Even grouping Asia ex-Japan together is somewhat problematic. The region has the world's emerging power, China, which is battling a credit hangover from 2009. India has its own domestic problems, via a combination of slowing growth and still high inflation. South-East Asia has been travelling better, though Indonesia appears vulnerable given commodities account for more than 50% of its exports. In other words, Asia is a diverse region and countries within it won't all grow at the same pace. Far from it.
Generalising, however, Asia ex-Japan still offers the world's best growth story. Compared to developed markets, Asia GDP growth is far superior, its balance sheet is sounder and the region's younger demographics should provide for more productive workforces.
In addition, Asia ex-Japan is cheaper than many developed markets. Its 12-month forward price-to-earnings ratio (PER) of 11x is almost 30% cheaper than the S&P 500 PER of 15x. Asia also offers a better dividend yield of 2.8%, 35% higher than the S&P 500's 2.1%.
Top picks are India and Thailand
Within Asia, the best opportunities are likely to be in countries whose growth is driven more by domestic consumption than exports. That's because rising wealth (driven by increased wages) translates into strong domestic consumption, particularly off a low base as is the case in Asian countries. Those reliant on exports may prove less compelling investments given the tepid growth in developed markets, which may remain for many years to come.
In our view, the two stand-out opportunities right now are India and Thailand. Today, we'll briefly focus on the more controversial recommendation of India. Though GDP growth is at decade-lows and the inflation risk is ever-present, there are positives changes in India which may provide both short and long-term catalysts.
In the near term, the investment cycle in India is showing signs that it could soon pick up. The long down-cycle in investment has been driven by rising interest rates to ward off inflation, a shambolic power sector and subsequent shortage of coal and a shambolic bureaucracy afraid to make decisions given numerous corruption scandals among high-ranking officials.
There's been some progress on each of these fronts, raising hopes of an investment rebound. First, the Finance Minister Palaniappan Chidambaram has been using canny judicial powers to force through price increases for electricity distributed by the State Distribution Boards (SBDs). SBDs have suffered chronic losses and debts due to politicians being unwilling to pass on the full costs of electricity to their electorates. The recent electricity tariff increases will go some way to reducing SBD debts and provide an incentive to produce more power.
Second, the Finance Minister has also set up a special committee on investments to fast-track projects, to bypass bureaucratic inertia. And according to CLSA's Chris Wood, the word is that US$25 billion in projects have been approved since December.
There are other changes in India that also bode well for the long-term:
1) Steps have been taken to cap the subsidies on fertilisers. These subsidies, along with those for food and petroleum, have escalated dramatically since the financial crisis as the Congress Party tries to buy off rural voters. They are the central reason why inflation remains an issue in India. The cap on fertiliser subsidies is significant in this context.
2) Work on providing a unique I.D. and card to all Indians is progressing well. This mammoth task, being undertaken by the former head of tech giant, Infosys, has already signed up 245 million people to the system. One of the key potential benefits of this system is that it may help to cut out the middleman in transactions, a key problem in India.
3) Several state governments are showing impressive economic growth through more business-friendly policies. The state of Gujarat is often cited, but there are four or five others which are equally impressive on this front. There is hope that these examples may have a domino effect across India's 28 states.
4) The proposed introduction of a value-added tax is way behind schedule but should go ahead in a diluted form. It should raise the tax take by 3-4% of GDP, from the current low level of 17%. This may go some way to reducing the money printing tendencies of the central bank.
This is not to suggest that India doesn't face significant hurdles, particularly with the political shenanigans that will precede next year's general elections. But it's worthwhile remembering that India has had its fair share of issues over the past 20 years, with many inept governments along the way, and it's still managed to produce real economic growth of 6.7% per annum. Some of the above changes indicate that India may continue to surprise in future. When combined with reasonable valuations, with a 12-month PER of 13.9x well below the 16.5x historical average, it makes India an attractive long-term bet.
This post was originally published at Asia Confidential: http://asiaconf.com/2013/06/09/emerging-market-opportunity/
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