China to South Africa, an emerging opportunity but risks remain
For the first time since the US Federal Reserve triggered a sharp sell-off in emerging markets (EMs) in May 2013 by signalling an end to its programme of quantitative easing (QE), a growing number of investment strategists are sounding more sanguine about the prospects for developing economies.
All of a sudden, one of the dominant macroeconomic themes for 2016 is whether it is finally time for investors to start increasing their exposure to EMs.
From a valuation standpoint, there is a compelling case to be made that EM equities have reached a bottom and now represent a buying opportunity.
Between September 2014 and late January of this year, the MSCI EM Index, one of the main gauges of the performance of EM stocks, plunged 37 per cent in dollar terms (with half of the decline occurring over the past year). During this period, the benchmark US S&P 500 index has fallen by a meagre 1.4 per cent.
According to JP Morgan, a staggering US$64 billion gushed out of EM equity funds last year, following outflows of US$28.5 billion in 2014.
EM stocks are now “exceptionally cheap”, according to Research Affiliates, a sub-adviser to Pimco, one of the world’s largest asset managers. The cyclically adjusted price-earnings ratio fell to 10 in late January – only the sixth time in the last 25 years that the measure has fallen to (or dipped below) 10, making “the exodus from [EMs] a wonderful opportunity – and quite possibly the trade of a decade – for the long-term investor”, according to Research Affiliates.
Just as importantly, EM currencies, which along with the stocks of developing economies have been among the most beaten-up asset classes over the past several years, appear to be over the worst of the rout.
The recent weakness of the dollar, a tentative recovery in oil prices and easing concerns about China’s economy have buoyed EM currencies, with some of the most vulnerable ones, such as the Brazilian real, the Russian rouble and the South African rand, strengthening 8-12 per cent against the greenback since late January.
Having fallen more than 10 per cent since September 2014, the Bloomberg JP Morgan Asia Dollar Index, a gauge of the performance of Asia’s currencies against the greenback (excluding the yen), has risen 1.7 per cent since mid-January.
Indeed, in a survey of EM investors conducted by JP Morgan earlier this month, only a third of respondents believed EM currencies would weaken against the dollar in 2016, with the rest predicting either mixed performances depending on the currency or an appreciation versus the greenback.
The big question is whether the recent improvement in sentiment stems from purely technical factors or is a reflection of improving fundamentals.
Unfortunately, nearly all the evidence points to the former, questioning both the rationale for, and the sustainability of, the rally.
EM asset prices are rising because investor positioning has become slightly less bearish after several years in which investors cut their exposure to developing economies significantly.
Yet the vulnerabilities in EMs have not disappeared. Investors have simply become less sensitive to them as broader sentiment has improved.
Quite aside from the fact that underlying fundamentals have yet to improve – there are still major concerns about China’s economy and policy regime, the supply glut in the oil market reduces the scope for a sustainable recovery in prices while slowing growth and mounting private sector indebtedness in many large developing economies are still a focal point of concern – sentiment still remains fragile.
Over two-thirds of investors who took part in the JP Morgan survey believe low commodity prices and a hard landing for China’s economy remain the biggest risks in EMs.
Much hinges on the outlook for the dollar.
If the Fed puts off further rises in interest rates this year – a hike at next week’s closely watched policy meeting is highly unlikely – and strikes a more dovish tone, the dollar could remain on the back foot, with the dollar index (a gauge of the greenback’s performance against a basket of its peers) already down 2 per cent since late January.
This could provide a solid underpinning for a further rally in EM currencies.
On the other hand, the Fed may end up surprising bond markets by hiking rates more aggressively than anticipated – particularly given the recent signs of a pick-up in US inflation.
Previous EM rallies have ended abruptly because of investors’ increased sensitivity to the conduct of US monetary policy and China’s woes. This time may be no different, with the added challenge of waning confidence in the ability of central banks to stabilise markets.
Nicholas Spiro is a partner at Lauressa Advisory