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South Korea's Financial Services Commission chairman Choi Jong-ku is handed the reins to a bull during a ceremony celebrating the first trading session of 2019 at the Korea Exchange in Seoul. Photo: AFP
Opinion
Macroscope
by Nicholas Spiro
Macroscope
by Nicholas Spiro

Why emerging market bulls need to rein in their optimism

  • Nicholas Spiro says investors are bearish about the US but increasingly bullish on emerging markets. But, while the worst seems to be over, emerging market stocks may only seem safer because Wall Street had a dreadful December
Nicholas Spiro
Nicholas Spiro
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One would be hard-pressed to find an investor with a resoundingly bullish view of global markets in 2019. Following a dreadful fourth quarter that left almost every leading asset class in the red for the year for the first time since the 1970s, a profound trepidation pervades the world’s trading floors.
While few expect this year to be as bleak as 2018, the surge in volatility – day-to-day moves in United States stocks last quarter were the most dramatic in years – has made it extremely difficult for investors to make bets on any major asset class with strong conviction.

Yet, while the mood is one of “extreme bearishness”, according to a December Bank of America Merrill Lynch fund manager survey, there is increasing optimism about developing economies, the asset class that bore the brunt of the price declines for most of 2018. The survey notes that emerging markets are now the most popular region among equity investors, who have not been more bullish about emerging market stocks over the next 12 months since July 2009.

Optimists can justifiably point to a number of factors that suggest emerging markets have turned the corner.

Indian labourers work on a rail link in Ahmedabad. Investors are bullish about emerging markets, which include India. Photo: AFP

The most obvious one is the outperformance of emerging market stocks in the final two months of last year. While the MSCI All-Country World Index, a leading gauge of global shares, fell 7 per cent – more than half the index’s decline for the entire year – the MSCI Emerging Markets Index rose more than 1 per cent. And emerging market stocks were less volatile than US equities, which had their worst December since 1931, according to Bloomberg.

Think emerging market stocks are having it rough? Just look at Europe
Emerging market currencies have also been more stable of late. Having plunged 8 per cent between late March and early September last year, the MSCI Emerging Markets Currency Index has since risen 1.8 per cent. The currencies of developing countries are benefiting from the recent weakness of the US dollar, which could become more pronounced in the coming months if the US economy loses steam and the Federal Reserve then pauses its rate-hiking cycle just as other major central banks start to normalise monetary policy.

In a November report on the outlook for emerging markets, Morgan Stanley said “a weaker growth outlook in the US should help to rebalance capital flows back into [emerging markets] that in recent quarters have left seeking the higher returns provided by [US] assets”.

Yet, for many investors, the most compelling argument for emerging markets is simply cheaper valuations, especially in beaten-down equity markets. The forward price-to-earnings ratio of the Emerging Markets Index has fallen to 10.5, down from 13.2 in January 2018 and the lowest since January 2016, when worries about China’s economy and markets were more acute than they are today.

Why must China ‘quench the thirst’ of economic slowdown?

As the bulls see it, emerging markets suffered a sharp sell-off much earlier than other asset classes and are thus better placed to cope with further volatility, whereas US markets, where selling pressure still remains, are in a more vulnerable place.

Still, while there are grounds for optimism, there are also reasons to be wary. First, it is difficult to be bullish about developing markets when China’s economy continues to deteriorate. In a private survey released on Wednesday, a purchasing managers’ index which tracks China’s manufacturing sector fell into contraction for December, for the first time since May 2017.

The slowdown, exacerbated by the US’ trade offensive against China, is spreading to other Asian manufacturing sectors. Following the release of the survey, the MSCI Emerging Markets Index fell 1 per cent: clearly, the health of China’s economy and Beijing’s response to the downturn remain key determinants of sentiment.

Second, the main reason why emerging markets look more attractive right now is that they are no longer the epicentre of the sell-off, which has shifted to US assets – specifically equities and corporate bonds – since last October. So it is only from the standpoint of market psychology that emerging markets have seemed a safer place in the past couple of months.

Just how badly is China’s economy doing?

Yet, the fact remains that emerging market stocks lost 19.5 per cent last year, compared with a 6.2 per cent decline in the S&P 500. More importantly, a slowing economy and turbulent markets in the US are hardly solid foundations for a rally in developing economies.

The worst is almost certainly over for emerging markets, but investors would be well advised to adopt a cautious stance as the year unfolds.

Nicholas Spiro is a partner at Lauressa Advisory

This article appeared in the South China Morning Post print edition as: Why emerging-market bulls need to rein in their optimism
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