Today, while growth rates in many emerging markets remain well above those in developed markets, we believe emerging market equities are nevertheless currently generally unattractive.
The competitive positions of these countries are being impacted by a range of developments, while lower levels of liquidity on their markets have made them vulnerable to outflows provoked by Fed tapering. Furthermore, historically strong growth was supported by a high level of credit expansion.
Those days are over.
Given Chinese growth rates over the last 20 years, for example, a slowdown there was inevitable. Also, the fact that some countries are now evolving from industry-led to consumer-led models can be linked to greater vulnerability and reduced government stimulus. This slowdown has had a negative impact on growth in Asia, in particular, and on the risk appetite of investors.
The so-called ‘Fragile Five’ (Brazil, India, Indonesia, South Africa and Turkey) are especially at risk due to current account deficits, low currency reserves and dependence on external debt.
Some of these countries earlier lived beyond their means or were simply managed poorly; it’s no surprise they now suffer from structural imbalances. Last year, their currencies declined some 20% on average against the dollar, leading to increasing inflation.
An additional challenge is the rise in food prices due to adverse weather conditions. As a consequence and to avoid social unrest, a range of emerging market governments have increased the minimum wage and/or enhanced the social safety net.
Such moves may be well intentioned – but wages in many of these countries were already trending upward. In China, for example, wages rose 18% annually over the last decade.
The decline of the Japanese yen and the American energy production revolution have also worsened the competitive positions of many developing nations, especially those that depend on energy exports.
Markets such as Brazil and Russia, which export hard commodities, are facing particularly soft demand and overcapacity, putting exports under pressure. In the longer term, we will reach an inflection point when exports start rising again thanks to lower exchange rates – but we’re not there yet.
Political issues also remain key factors for financial markets, as can be seen by the turmoil caused by rising tensions in Thailand, Turkey and Ukraine.
By comparison, thanks to their strong manufacturing bases, markets such as Mexico, South Korea and Taiwan enjoy a rosier outlook. The liberalization of the Chinese capital markets could also prove a positive trigger.
More generally, we don’t expect the disruption to be as severe as during the 1997-98 Asian crisis, as the currency regimes of emerging countries are far more flexible and depegged from the dollar. The level of currency reserves in many countries is also much higher than in the past, and the banking system has already been reformed.
Since the late-1990s, we have witnessed the increased globalization of the world economy – and the greater relative importance of emerging markets to it. As a consequence, systemic global risk linked to developing markets has increased.
Today, however, developed markets have less flexibility in their monetary policies to cope with a severe slowdown. At the same time, emerging markets are now experiencing the kind of rise in private-sector bad debt that developed markets saw just before the start of the global financial crisis.
So why not still buy emerging market equities on the dips?
Current emerging market equity valuations, with price-to-earnings of 10, do seem to be more appealing than in developed markets (above 14). But cheap valuations don’t entirely compensate for deteriorating profit growth (due to higher wages, interest costs and overcapacity). Also, these seemingly low P/E ratios are somewhat deceptive, considering the high level of dependence on banking and the low valuations of this sector.
Looking at price-to-book ratios, emerging markets are certainly not cheap measured against developed ones, especially by historical standards. This is why we prefer equities in safe-haven markets like the US and Europe, where growth rates are accelerating. As well, Japan could enjoy further monetary easing later in the year.
When it comes to emerging market bonds, we see greater opportunities. Yields are more attractive, and some of the arguments we have made against equities can actually favor bonds.
The slowdown in GDP and profit growth could lead to declining spreads. Inflation is being addressed by rising short-term rates – in Turkey and South Africa, for example – also leaving room for bond yields to decline.
The debt positions of governments overall are in good shape. Also, the fact that the asset class of emerging market debt is dominated by institutions could prove positive as their investment horizon is longer term. Finally, due to ALM issues, they prefer to seek risk exposure in fixed-income assets instead of equities.
So there is a silver lining in emerging markets – but it is not in equities, at least for now.
Ms. Valke serves as Senior Investment Strategist at Amsterdam-headquartered Theodoor Gilissen, a member of KBL European Private Bankers. The statements and views expressed in this document are those of the author as of the date of this article and are subject to change. This article is also of a general nature and does not constitute legal, accounting, tax or investment advice.