Investors weigh value versus risk in emerging markets

Investors have been offloading emerging-market assets in droves based on a number of factors, particularly economic growth fears and US dollar strength. Whether such broad-based aversion is merited is open to question.

In August the Institute of International Finance (IIF) estimated EM outflow at almost $300 billion, based on data from the previous four quarters.

Although large, it was less than a third of the startling $1 trillion outflow figure over the past 13 months published by the Financial Times. “Don’t panic! EM capital flows have weakened, but not collapsed,” stated the IIF.

Jan Dehn, head of research at EM-focused Ashmore Investment Management, noted that its calculation of outflows – between $183 billion and $295 billion – amounted to less than 0.9% of total tradable debt and equity in the EM universe.

“Ignorance and prejudice about EM are rife,” he seethed. “When combined they can become dangerous. When they fuel misleading, sensationalist media headlines they remind us there is no substitute for independent thinking when it comes to EM.”

Because they are less liquid than developed markets, EMs are more sensitive to broad-based selling by short-termist retail and high-net-worth investors via mutual funds and exchange-traded funds.

Diminished liquidity and consequent price volatility will deter institutional investors from providing the sort of long-term capital these markets crave. Hence Dehn’s sensitivity.

Notwithstanding his commercial motivation as a big EM investor, Dehn urges perspective. Emerging markets comprise 57% of global GDP, he notes, but account for less than 15% of tradable debt.

He seeks to explain the reasons behind global investor nervousness that now sees global equities only neutrally valued (average yield 6.4%) even as “risk-free” global sovereign bonds (average yield 1.1%) are so expensive.

Dehn pins the blame on prolonged quantitative easing policies that have underpinned the performance of developed market trades such as US stocks and core US dollar and European government bonds.

Of course, such trades have suffered in 2015, with US stocks down (S&P500 Index -0.72% year-to-August 28), the US dollar index DXY down 4.2% from March and core European bond markets suffering big losses since April.

At the heart of these falls lie the strengthening US dollar and zero-to-negative yields. Dehn suggested the thing that no-one ever imagined could come to pass, “namely that limits to what hyper-easy monetary policies can achieve has happened. If the drugs no longer work, what’s next?”

He argued policymakers had squandered the good times for developed market assets over the past four years by not undertaking sufficient deleveraging and reforms.

“Now we are stuck with overvalued asset prices, weak, unproductive and heavily indebted economies and no obvious way forward,” Dehn noted. “These huge uncertainties cloud the outlook for returns in developed markets and, as per normal, adversely affect sentiment towards EM.

“But it is developed markets, not EM, that are over-indebted, slow growing, money printing and unable to reform. They are also the more expensive markets, by far.”

Valuation vs earnings
On a valuation metric, emerging market equities are currently trading at a 35% discount to developed market equities based on the trailing price-to-book metric. But presumably it is doubts over earnings that are causing investors to panic, given that global emerging markets are dominated by commodity producers and commodity prices have collapsed.

The Bloomberg Commodity Index of 22 raw materials from oil to metals closed at 85.85 on August 24, its lowest level since August 1999 – before the 2000s commodities boom. It had risen slightly to 88.78 at press time on August 31.

Investors have been overweighting developed markets due to the fall in commodity prices, and with demand lower in the West, they are not expecting to see an earnings pick-up in EM anytime soon.

Nicholas Ferres, investment director for Eastspring’s global asset allocation team, noted that while the EM index was trading at about 11 times earnings, it typically troughs at eight times. There’s more room to go down from here.

While EM credit spreads (both dollar and local) are above average, outright yields are still only neutral from a historical context.

Ferres added that foreign ownership in local bond markets was typically between 15% and 35%, meaning they are very vulnerable to sell-offs. Malaysia is 15% and Indonesia 30%, for example.

“This could exacerbate the [EM] correction, despite much stronger external positions [on average] relative to history,” said Ferres. “Maybe the growth scare in emerging markets is broadening out and could be self-fulfilling.”

Playing the waiting game
Whether investors go searching for value now depends on their timeframe. Anticipation of the pending, yet well sign-posted interest-rate hike by the US Federal Reserve is a driving force.

But Ben Luk, global market strategist for JP Morgan Asset Management in Hong Kong, notes differences between EM positioning now and in 2013 when then-Fed chairman Ben Bernanke first raised the prospect of tapering the US quantitative easing programme, sparking an EM sell-off.

He observed that investors had a much lower positioning in emerging markets now than in 2013, with EM’s share of global equity flows having sunk from 30% in 2013 to less than 15% this year, combined with net outflows for EM debt over the past two years.

Moreover, many EM currencies traded at a premium prior to the taper tantrum, but now most outside of China are trading 10-20% below their 10-year real effective exchange rate (Reer) average. Emerging-market currencies have adjusted to these much lower levels.

“That means the potential [for currencies] to fall lower is much less [than in 2013],” stated Luk. “Overall the situation [for EM] remains much more comfortable [than in 2013].”

The question for investors is whether they think they are being compensated for the risk of investing in EM amid slowing global growth – which should see default risk rise.

In terms of EM bond yields, US dollar-denominated EM debt was trading at 4-4.5% yield to maturity in May 2013, versus 6-7% now. That is against an average of 5.8% over the last five years.

“While there is no doubt that headwinds remain for emerging markets,” said Luk, pointing to fears over US tightening, weaker short-term growth prospects and an increase in corporate leverage, “much of these fears have already been reflected in depressed valuations across EM currencies, bonds and equities.”

Yet Luk conceded he was reducing his EM positioning. “The valuation is cheap, but we are not at a level where we think it is reasonable to tap,” he said.

He outlined three factors he wants to see before re-allocating to EM: a stabilisation of commodity prices; a stabilisation in China’s economy (likely through continued economic stimulus); and recovery in Europe, which accounts for 72% of bank lending to EM, versus 17% for the US and 11% for Japan.

Of course, that is not to say there are not opportunities, which plays to Dehn’s point about the need for investors to think independently about EM.

One of the brightest spots is India, which as a commodity importer is benefiting from the cheap prices (as is Korea) while committing to structural reforms.

Ferres said the correction in EM had opened up value opportunities in EM equity, credit and currencies. He is overweight equity markets in North Asia.

He noted, too, that correction in Southeast Asia had also presented opportunities in carry currencies (Malaysia and Indonesia), with the ringgit approaching 1997 trough valuations while the nation was running a $2 billion trade surplus.

But the downward spiral in commodity prices makes it tricky to raise exposure to EM, even if managers are convinced some EM currencies such as the Indian rupee, South African rand and Brazilian real will represent good value at some point.

Ferres is convinced investors are still scarred by the global financial crisis. “Too many are still thinking about the downside risk, not upside,” he reflected.

But divergent monetary policies are clouding the picture. The market volatility of August is perhaps a reminder that volatility has been kept too low for too long.