Last summer….the July 8th
posting to be exact….these pages first ventured into the subject of emerging
markets. At the time a bullish argument was put forth for long term….or secular in jazzy investment parlance….growth
in these rapidly developing/urbanizing/industrializing regions. Presently when
looking at a screen on year-to-date returns across global equities, one cannot
help but notice the glaring sea of red in the emerging markets section. During
a period in which the S&P 500 has gained a respectable 10.9% (even after
Wednesday’s decline) and the Eurostoxx 50 has risen 2.88% despite the perpetual
bleeding of lousy headlines emanating from that region, emerging markets as
measured by the broad MSCI Emerging Markets Index have dipped 1.2% this year in
local currency terms.
When viewing the chart above and
seeing the underperformance of a putatively good source of juicy returns, one
may question the cynical premise…..often posited here….that the extraordinary
easy-money polices of the Fed and its peers in Frankfurt and Tokyo may lead to
bubbles in risky assets such as emerging markets. But rather than offering up a
mea culpa to last year’s bullish proposition, we should remind readers the difference
between a multi-year secular trend and a (likely deserved) short-term
correction to allow the market to blow off some frothiness. And was there ever
frothiness. In fact, when the recent rally was ignited upon the Fed’s announcement
of its third iteration of quantitative easing, emerging market shares rose
toe-to-toe with global indices. And this was on top of a strong spring rally,
which all together saw the MSCI EM index gain 17.9% over the latter part of
2012.
Dialed down expectations of global
growth…most of which having been provided by emerging economies since the onset of the twin
financial crises…and good old fashioned profit-taking are likely the culprits
behind the 2013 dip in EM shares. The real…and more frightening…question is why
haven’t major indices like the S&P 500 and Russell 2000 blown off any
steam? At over halfway through U.S. earnings season, analysts are still fretful
at the lack of top-line growth for S&P 500 firms; this year is experiencing
the third consecutive spring-swoon in economic data; and Europe is still in the
grips of recession. Where have such suspect fundamentals led us? To nearly
1,600 on the S&P. Go figure.
Emerging Markets Revisited
Rather than rehashing the entire
justification for emerging markets exposure, let’s just leave it to two facts,
their growth continues to outperform that of developed markets, and as their securities
markets continue to liberalize, there will be greater demand from investors eager
to get a slice of the pie, especially in light of the laughable yields found in
other, purportedly safer, asset classes. Prior to the financial crisis,
emerging market growth was a pleasant surprise for investors. Since then, their
still respectable growth rates have been a life saver, not only for portfolios
but also by being a key source of demand in the real economy. As seen in the chart below, the growth
registered by the BRICS and other major EMs over the past three years makes
western policy makers weep with envy. Even if growth does dip in coming quarters, it
certainly beats the sub-2% purgatory in which major advanced economies find
themselves.
The table above also highlights the
superior fiscal position of most of these countries vis-à-vis developed
markets. Russian debt to GDP at 10.9%? China’s at 22.8%? Italy or the U.S. post-stimulus (and
Obamacare) these are not. Yes, inflation
remains a bugaboo for these countries and many have a spotty history of
fighting rising prices, but that is why one also sees central bank interest
rates (last column) in the range of 4% to 9%. Keep in mind the Fed Funds rate
is locked between 0% and 0.25% for the foreseeable future. The ECB will likely
lop another 25 bps off its 0.75% key rate on Thursday and the Bank of Japan’s
rate is a miniscule 0.1% as the country continues its decade-long battle
against deflation.
Such interest rate differentials
between advanced and emerging economies provide even further underpinnings for
emerging market exposure. Not only are their central banks serious about
containing inflation while the Fed may be sowing the seeds for the Weimar
Republic Version 2.0, which will gut domestically-denominated savings, but such
differentials create the opportunity for positive carry simply by gaining
exposure to assets denominated in EM currencies. This was the rationale behind
yield-starved Japanese pensioners buying Aussie Dollar assets in the years
prior to the crisis and why they are likely buyers of fat yielding Italian
government bonds today. Their central bank has forced members of retirement
communities to adopt a hedge-fund manager mentality. The quicker U.S. and
European investors…even in the retail segment…wake up to this tactic the better.
An Evolving Investment Landscape
In the wake of the autumn 2009
bloodbath, investors have shied away from equities, even as major indices
doubled their recession lows. Evidence of this has been found in the steady
drip of money out of equity funds. In the past year, investors have begun
dipping their toes back in the equity pool, but namely in non-U.S. markets. This
trend will likely continue the market plays catch up with the 21st
century economic landscape.
As seen in the chart above, emerging
markets currently account for 38% of global GDP, a figure that has grown steadily
over the past two decades and one that is expected to continue. This is in
sharp contrast to the world’s equity markets. Emerging markets currently
constitute only 11.5% of the S&P Global Broad Market Index. If one wants to
include all emerging market equities, including illiquid, opaque junk, the share
is likely a bit higher, but there is good reason S&P does not include them
in this barometer. Not only do many regions not have functioning equity
markets, but some that do often have lousy track records with regard to
liquidity, transparency, contract law and shareholder rights. No
wonder that emerging markets presently take up such a small slice of global
equity portfolios.
Yet that too shall change. These
countries need capital and equities markets are a proven channel in which to
attract it. As a consequence laws will be beefed up and state assets will be
auctioned off as has occurred (to varying degrees of success and morality) in Eastern
Europe and Asia. As these exchanges are established and fortified, investor
demand should rise accordingly, especially if advanced markets continue to
offer up low returns.
Going Granular
As was pointed out last summer, not
all emerging markets are the same. Nor is equities exposure to the theme a
homogenous, top-down play. Instead, and as evidenced by the crisis, the global
economy is intricately interwoven and still when the U.S. sneezes, much of the
rest of the world is likely to catch cold. Decoupled: we are not there yet. Many market sages point to the need to gain
exposure to sectors dependent upon internal emerging market growth rather than
those in tune with the global business cycle. Examples of the former include
the rise of the EM consumer, the need for infrastructure investment (roads,
power grids….flush toilets), banking for underleveraged private sectors and
home construction (which China has evidently taken a step too far). Globally
sensitive sectors include the likes of energy, basic materials and technology.
A good-bad example of the still
real risks in EM investment is the recent trajectory of Russia’s benchmark RTS
equities index. Its post-QE3 rally was stronger than many other emerging
markets, but its 2013 sell off has given back all those autumn gains. The RTS
not only illustrates how volatile EM shares can be, but also the risks of concentration
in a few sectors, especially globally sensitive ones such as energy and mining.
Worse yet, a major market for Russian energy products is the atrophying
European Union. Such interconnectedness has battered other Central European
exchanges as well. Of course Russian authorities have not helped themselves
given government control of key boardrooms and sectors. Yes I have a soft spot
for the place being that it has produced both Dostoyevski and Maria Sharapova,
but it has also given plenty of western investors severe headaches. Just ask
BP.
Marching On…With Requisite Caution
With regard to the fundamentals such
as demographics, growth rates and interest rate differentials, the
justification for emerging market exposure is still valid. As evidenced by its
weak 2013 performance, legacy issues such as volatility are still present as
well. So are other red flags like transparency, majority state ownership in key
sectors and yet-to-be proven inflation fighting chops in some countries. Still, the
2013 sell-off may be a sign of maturity in these markets. After all, the
bullish rationale just mentioned has been baked
in to valuations for some time. Add the QE3 jolt to the mix and after six
weeks and 10%, investors did what they are supposed to do when markets get ahead
of themselves: they took profits.
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