Despite Weakness, Emerging Markets Not Dead Yet

Feb 6 2014, 4:32pm CST | by

Emerging markets are doing better than sentiment suggests.

Despite that, Fed tapering from its asset purchasing program this year worries investors. China’s housing bubble and growing concern over a possible credit crisis there aren’t helping. Last month, the Industrial and Commercial Bank of China got support from the government to bailout out a $420 million wealth management product called Credit Equals Gold #1.

“Investors know that every time the Fed reaches an inflection point in policy, there’s some crisis in an emerging market,” says Bryan Carter, a fund manager at Acadian Asset Management in Boston. “What investors forget is how emerging markets have changed over the years. Most of these countries don’t have the probability of default. They don’t care if their currency weakens.”

Investors this year remain focused on the U.S. economy and the European recovery. Japan has taken a backseat and is underperforming some emerging markets in Asia.  And on Asia, investors who used to love a good China bull story, now seem like they cannot get enough of the bear case.

Retail investors have been pouring out of emerging market equity and bond funds, according to fund tracking firm EPFR Global in Cambridge, Mass. Still, even taking a passive, top-down approach to emerging markets, some are beating the very economies investors love.

The iShares MSCI Germany (EWG) exchange traded fund is down 5.26% year-to-date, while the Market Vectors Indonesia (IDX) ETF is up 2.12%. The SPDR S&P 500 (SPY) ETF is down 4.04% YTD, but Market Vectors Vietnam (VNM), Market Vectors Poland (PLND) and iShares MSCI Thailand (THD) are beating it.

Last year’s darling Japan is down 7.2% compared to last year’s BRIC basket case India, which is down 6.01% as measured by Wisdom Tree India Earnings (EPI).

“A slowing Chinese economy and declining emerging market corporate profitability over recent years are all feeding negative sentiment and have led some critics to herald the death of emerging markets. We believe the fundamental investment case for the asset class nevertheless remains intact,” says Devan Kaloo, head of emerging markets for Aberdeen, a $320.6 billion asset manager from the U.K.

The big four emerging markets, known as the BRICs, grew up at a time of high liquidity and massive debt in the advanced economies. Consumers in the U.S. are now deleveraging, buying less Made in China goods, which in turn means China is buying less Made in Brazil iron ore pellets to feed its own development.

Emerging market currencies were gaining on the dollar almost daily. In June 2008, the Brazilian real was worth R$1.55. Today it is worth a much weaker R$2.40. For some countries, cheaper currencies could — in theory — help boost exports, while higher interest rates there slow domestic growth and imports.

“We believe this will eventually lead to an improvement in current account positions, underpinning currencies and allowing interest rates to come back down,” says Kaloo. Investors have been growing wary of deficits in countries like India and Brazil over the past two years, adding to poor investor sentiment.

Moreover, emerging market corporate profitability has declined as companies have had to contend with slower economic growth and margin pressures from rising capital and labor costs. In contrast, developed market companies, particularly in the U.S., have seen profitability hold up as they have taken costs out of their businesses and have implemented significant share buyback programs.

China remains the elephant in the room. Beijing is pursuing interest rate liberalization and consumption-led growth as a means to address the fundamental misallocation of capital, particularly at the municipal level. This has consequences for global and emerging markets growth as China’s economy slows and the nature of its imports change. China will build less. This could pressure jobs. The economy will struggle to grow over 7.5%.

In a worst case scenario, Beijing has the money and the reins to steer the economy wherever it wants. The banking system remains well capitalized despite increases in non-performing loans and a closed capital account gives the authorities greater control of the situation. New leaders, now nearly a year in office, have laid out a number of economic reforms that, if pursued, will provide better investment opportunities in China.

Today, emerging markets make up 40% of the world’s GDP – compared to 14% in 1997 when the Asian crisis started in Thailand, wiped out the so-called Asian Tigers, spread to Russia and saw the end of dollar-pegged currencies in that part of the world.

Times have changed, but investors have not forgotten what the Fed can do to emerging markets.

Many emerging markets now run structural account deficits and therefore have to rely on foreign capital inflows to maintain value of their currencies. Others, like Brazil, have to tap into their foreign currency reserves to save their currency from speculative attacks./>/>

The final point in all this is the dollar,” says Mauro Ratto, head of emerging markets for Pioneer Investments, a $230 billion asset manager in London. “A strong dollar has made life much more difficult for emerging markets. Even now I think the dollar is undervalued,” Ratto says. “I know that is not consensus, but when interest rates rise in the U.S., the dollar will get stronger.”

Even long term global investors worry that a strong dollar means weaker emerging markets.

“Everyone is looking for a big policy movement,” says Carter from Acadian. Wednesday’s European Central Bank announcement that it was keeping interest rates flat was one such movement. A lower rate would have been better news for emerging markets even though the MSCI Emerging Markets Index rose 2% today.

“It is hard to call tops and bottoms. A deliberate and diversified approach is probably the most prudent way to buy in now,” Carter says.

Source: Forbes Business


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