Currency rout to further drag down EM markets
Emerging market currency weakness will likely spread to stock markets, at least in relative terms, which means the rout in equity markets has not yet reached the end of the tunnel.
The bloodbath in emerging market currencies, which just fell to their lowest level in years, could lead to further capital outflows and opens further downside for emerging market stocks, AXA Investment Managers said in a note to its clients.
Unlike developed markets such as Japan and Europe, where a weaker currency is clearly positive for the markets, emerging Asian countries’ currencies and the relative performance of equities move hand in hand.
Emerging currencies have already lost between 25 and 30 per cent since then-Fed Chairman Ben Bernanke’s ‘Taper tantrum’ remarks back in May 2013. Emerging equity markets have been lagging developed markets performance since late 2010. The markets have stayed flat while the MSCI World Index returned around 70 per cent.
“Most worrisome is the fact that the relative performance of emerging markets is positively correlated with the foreign exchange rate,” said AXA. “Further currency weakness will weigh on emerging market equities. It is not the time to be brave.”
“We think that the real litmus test – the divergence in monetary policies of the US and emerging markets – still lies ahead.”
Most emerging currencies are now trading at the lower range looking out over the past 15 years. For instance, Indonesia’s rupiah fell to its weakest level since the Asian financial crisis 17 years ago, while the Malaysian ringgit also hit another 17-year trough on Monday.
What’s really behind the sharp corrections in both the equity and currency markets are weakening economic fundamentals, according to AXA Investment.
Investors dumped assets in the region because of their rising concern whether double-digit earnings growth is still sustainable, given that most emerging market economies have been built on a kind of a high-speed growth model which is now flagging.
Profit margins have weakened over the past couple of years while corporate leverage has increased, matching the heights of the early 2000s, according to AXA.
“We think that the current consensus earnings growth projections for the coming 12 months look overly optimistic. We would not be surprised to see analysts’ earnings growth forecasts of almost 10 per cent to be trimmed in the coming weeks,” it said.
“With the emerging markets’ high-speed growth model fading, structurally lower nominal global GDP growth implies single digit earnings growth going forward.”
Although emerging markets are trading at a decent valuation discount to its historical level, with 12-month forward price-to-earnings hovering around 13.5 times versus the historical level of 20 times, AXA argues that historical reference is no longer relevant.
“In such an environment we would argue that emerging markets should trade at a serious discount rather than around their historical average,” it said.
