Emerging equity markets – Sunshine after the rain?

Emerging equity markets – Sunshine after the rain?

After a stormy 12 months for emerging markets (EM), there is increasing optimism that the clouds are beginning to lift. Global growth is picking up, helped by the US and to a lesser extent Europe, while the latest data from China suggests that recent stimulus efforts are beginning to have a positive impact. On the other hand, the end of the commodity super-cycle is causing notable headwinds for some of the largest EM economies, such as Brazil, Russia, South Africa and a number of other Latin American counties. In addition, problems of ‘Dutch disease’ and a lack of proper investment in sectors beyond the commodity complex have left many economies exposed to the vagaries of global cyclicality. Given these conflicting forces, what is the outlook for EM asset prices and should investors once again look to allocate into these markets?

Other than underlying economic growth, one key factor driving EM asset prices is the extraordinary monetary policy actions being witnessed across the world. In developed markets (DM), we continue to see very low bond yields and relatively steep yield curves, which remain a positive backdrop for risk assets globally. In particular, the recent easing moves by the ECB show that a further leg to this remarkably persistent stimulus can be expected. In China, monetary policy is more difficult to read; Beijing is struggling to rein in an unprecedented credit boom which has seen the broadest measures of money supply rise well in excess of nominal GDP growth. Set against this is the fact that China has a strong balance sheet in aggregate, so it should be able to manage the property and debt deleveraging process relatively smoothly. In fact, with an economy that has recently shown many signs of slowdown, there is some evidence of China relaxing policy. This would be good news for markets in the short term, but more worrisome in the longer term if underlying problems remain unsolved.

EM monetary policy itself is more complex, giving few clear signals. Some countries are easing, some tightening in response to inflation and growth pressures. Peaking interest rate cycles in certain countries-Brazil for example - do offer the prospect of good returns from EM debt. However, at the overall asset class level these country-specific effects are dominated by the decisions of the DM central banks along with Chinese policymaking. Currencies across the EM complex feel like more of a ‘two-way bet’ than in recent years. This comes after corrections in foreign exchange within the context of the weaker balance of payment conditions than EM has enjoyed for much of the past decade.

Ultimately, the key to longer term performance in the EM asset class will be the ability of different countries to adjust to the new economic realities they face. Central to this discussion is the ongoing reform efforts in China. Such steps tend not to be positive for growth in the short term and the myopic nature of financial markets means that investors are in no mood to give China the benefit of the doubt in the face of growth downgrades and clear longer term macro risks. Elsewhere in EM, there are pockets of optimism though as regards to political change and reform drivers, offering country specific opportunities such as India. However for every success story there are other problem cases such as Russia or Turkey. Also, the Middle East remains a big event risk as regards to geo-politics, oil price (chart one) and the general sentiment for EM.

In assessing the outlook for EM equities, it is also important to consider the technical and behavioural elements driving these markets (chart two). After a long period of negative EM sentiment and relative outflows, these look to be turning. Typically this should be a positive time to be long the EM asset class in a tactical sense – or at the very least not underweight – albeit China’s debt problems and uncertainty over the strength of the DM recovery represent obvious reasons to be cautious. Politics remain a wild card for EM investors. There are several event risks on the horizon, with the Ukraine and Iraq obvious near term threats. However, if Iran is ‘brought in from the cold’ as a result of the Iraq insurgency, that could actually prove to be a significant longer term positive.

In conclusion, it appears unlikely that EM growth rates will return to the levels witnessed in the 2002-2008. Those countries that are most capable of adjusting to this new reality are likely to see strong performance, so rather than investing broadly in EM debt or equity markets country selection remains key.

Jason Hepner, Investment Director, Global Strategy, Standard Life Investments