Over the weekend, we highlighted [6] a new study by the Center for Global Development which identified the emerging markets that are most vulnerable to an “external shock” whether in the form of a Fed “liftoff” or a geopolitical shakeup such as a wholesale Russian invasion of Ukraine. With EM multiples, spreads, and currencies trading at a discount to their DM peers, some investors may be tempted to look for a relative value play in the face of increasingly overbought DM equities and fixed income.
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Despite what look to be "cheap" valuations, JPM calls the EM contrarian approach “tactically challenging” thanks to leverage, a difficult environment for economic growth and Janet Yellen:
EM equities are trading at much lower multiples than DM ones, its external bonds still offer high yield spreads over DM equivalents, and most of its currencies are some 20-30% undervalued versus the dollar. We meet few managers who claim to be OW EM. But there is no free lunch in EM as its fundamentals look daunting. We have found contrarian, value based strategies tactically challenging and usually prefer to see the start of some improvement in fundamentals and price momentum before diving in…
What are the current challenges to EM? In a nutshell, increased leverage and foreign borrowing, structural weakening of growth, and the coming end of easy Fed money. Each of these is a problem, in our view. In combination, they could be a serious problem. There will surely be episodic rebounds and outperformance in EM assets, but until at least one, if not two of these threats turn around, we will find it hard to expect medium-term outperformance of the full EM asset class..
EM growth has decelerated markedly…
To elaborate, EM growth has been slowing steadily and dramatically since the financial crisis, rebounding initially at 8% in 2010, but has likely fallen to below 4% this year. Productivity growth has come down globally, but more in EM than in DM, with EM labor productivity growth down to almost zero this past year, versus an average of 3-4% before the crisis...
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...while both the public and private sectors have taken on more debt…
Unlike the delevering that has spread across DM households, government and banks in the aftermath of the financial crisis, emerging economies reacted by ratcheting up debt, with bank credit now some 25% higher relative to GDP than before the crisis…
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...and the market fears the first casualty of a rate hike cycle may well be EMs...
The by now over 6 years of zero US interest rates are making investors wonder who will fall out when the Fed starts shaking the money tree and most have EM very high on this list, creating downside on the EM asset class as we approach the first rate hike...
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As a reminder, here's the breakdown of who's most at risk, and who's improved their position since the eve of the crisis:
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