Look carefully into the middle distance. Can we see the long-awaited bottom for emerging markets from here?
Market sentiment turned brutally and decisively against the emerging world five years ago. Since then, stock markets have steadily dropped further behind the developed world, currencies have devalued and countless indicators of economic health have grown ever more sickly.
Emerging markets have always been a story of commodities. It is the emerging world, led by China, that largely produces and consumes industrial commodities. In practice, at least when viewed through the lens of markets, emerging market stocks make up a complex with other assets tied to the health of the resources economy.
Some of those assets are now hitting the kind of lows that suggest the cycle cannot have much further to go. The price of iron ore in Qingdao, the widely accepted benchmark for Chinese metal consumption, is down 76 per cent from its 2011 peak. The broader Bloomberg industrial metals index is also at post-crisis lows.
The Baltic Dry index, a measure of the cost of shipping commodities around the world, subsided this week to its lowest ever. It has now dropped 95.5 per cent from its peak set in 2008, shortly before the financial crisis. Such numbers raise hopes that the cycle is ready to turn, and some analysts — notably Capital Economics of London, which has boldly suggested emerging markets are a “buy” for a few months — believe the bottom is close.
The sell-off in emerging market equities has pushed valuations to an all-time low, by one measure at least, reflecting the marked underperformance of the asset class since the immediate aftermath of the global financial crisis.
Emerging market equities have delivered a total return of minus 2.1 per cent since
Despite this potential buy signal, analysts are not queueing up to argue that emerging market equities are wildly undervalued.
“The latest leg of correction leaves emerging markets as the unambiguously cheap segment of global equity on a fundamental basis [but], with the exception of Russia, valuations simply haven’t become cheap enough,” says George Iwanicki, emerging markets macro strategist at JPMorgan AM.
The MSCI Emerging Markets Index fell to a valuation of just 12.8 times 10-year average earnings at the end of September, according to calculations by JPMorgan AM, taking it below the previous nadir of 13.5 times during the 1997-98 Asian financial crises.
The cyclically adjusted price-to-earnings multiple is now barely half its long-term average of 25 times average 10-year earnings.
In contrast, the US S&P 500 index is trading at 23.4 times cyclically adjusted earnings, within a whisker of its long-term average of 23.6. The MSCI Europe Index is at 15.1, against an average of 20.6.
The main divergence we have emphasized is in monetary policy trajectories. The first phase, which began late last year and will run through this month is other countries taking action to ease policy. The Fed stood pat. The second phase is when the Fed lifts rates and many others continue to ease, perhaps at an accelerated rate.
There is another divergence that is taking place. As thisGreat Graphic, created on Bloomberg, shows, the MSCI Emerging equity market index (yellow line) is widely under-performing MSCI’s World Index, which tracks developed countries’ equities (white line).
As the chart illustrates, in the first quarter, the two were comparable. When it become clear due to the weakness of US Q1 economic data that the Fed was unlikely to raise rates in June, the dollar fell and emerging markets outperformed in April and May. Commodities in general, and oil in particular rallied during then as well. The CRB index peaked in May as did oil. Emerging market equities unwound the overshoot, and by the end of Q2 were actually under-performing the developed equities by a fraction.
Between the end of June and late-August, oil fell by a third. The price of copper fell by a quarter from May through August. The Greek political drama and worries about the Chinese economy were also a weight. The reversal of the Chinese stock market also took a toll. From the February low through the June high, the Shanghai Composite rallied 70%. From the June high to the August low, the Shanghai Composite lost 45%, which was sufficient to push it to new lows for the year.
No, it’s not very scientific. Still, word counts from the minutes accompanying the Bank of England’s decision to keep interest rates on hold today help to understand what keeps the rate setters up at night.
The word ‘Greece’ gets just one mention, and that’s in a relatively positive light. (“The decisive result of the general election in Greece had reduced the risk of political deadlock in the near term, but had not materially altered the medium-term risks,” the BoE says.)
“China or Chinese”, meanwhile, get 11. UK rate setters are watching carefully.
Brazil too is on the radar, with a relatively glancing two mentions, but it is held up as a key example of the stress infecting emerging markets.
On that note, the BoE said: “Key questions were how pronounced the on-going slowing in the emerging market economies would turn out to be, and to what extent this would spill over to activity in the advanced economies.”
Oil had six mentions, in the context of its dampening impact on inflation, and the signals it sends on global demand.
Moments ago the IMF did what it does best: it just cut its forecast for global growth yet again. Specifically, it said that “global growth for 2015 is projected at 3.1 percent, 0.3 percentage point lower than in 2014, and 0.2 percentage point below the forecasts in the July 2015 World Economic Outlook (WEO) Update. Prospects across the main countries and regions remain uneven. Relative to last year, the recovery in advanced economies is expected to pick up slightly, while activity in emerging market and developing economies is projected to slow for the fifth year in a row, primarily reflecting weaker prospects for some large emerging market economies and oil-exporting countries.”
What is surprising about this particular estimate is that the IMF did not cut any of its core geographic regions: both Europe and China saw their 2015P GDP forecast remain unchanged (at 1.5% and 6.8%), while the US was raised modestly from 2.5% to 2.6% (it will soon revise this lower again). As a result, the driver for the cut in global growth was to a lesser extent Japan, which was revised from 0.8% to 0.6%, but it was the EM and oil exporters that saw the biggest cuts, with Russia (-0.4%), Brazil (-1.5%) and Canada (-0.5%) cut the most.
The culprit, indirectly, was once again China. To wit:
There are some good reasons for buying India. For one, companies there should improve their earnings at a healthy pace. Profit estimates, according to Credit Suisse, should compound at 12 per cent annually over the next two years. That compares well with the broader emerging markets at just 3 per cent.
Another reason: portfolio managers have relatively few options. India is the fourth-largest among the investable emerging markets. The largest three — Hong Kong/China, South Korea and Taiwan — represent more than half of the index. Each has strikes against it, either due to China’s perceived economic weakness or Japan’s more competitive currency. Add in commodity-dependent markets such as South Africa and Brazil, and almost two-thirds of the index looks unattractive to those seeking some decent growth.
India, on the other hand, has plenty of technology and service companies, relatively little China exposure and few commodity companies clogging up its index. Yet fund managers already own a lot of India. Relative to the MSCI emerging markets index, the average emerging market portfolio holds double the benchmark of 9 per cent.
Moreover, the price for that added earnings pace looks a tad high. MSCI India trades at 17 times estimated earnings, a 60 per cent premium to the broader emerging markets index that is near five-year highs. Fifteen years ago the market demanded a discount.
India’s equity market has some appeal for those wearing rose-tinted glasses. Unfortunately, that allure seems fully priced into shares.
The world economy is locked on a course towards an emerging markets crisis and a renewed slowdown in the US, despite the Federal Reserve’s decision last week to hold off on a rise in rates, according to one of 2015’s most successful hedge fund managers.
John Burbank, whose Passport Capital has placed lucrative bets against commodities and emerging markets this year, forecast that the Fed would eventually be forced into a fourth round of quantitative easing to shore up the economy.
In an interview with the Financial Times, Mr Burbank said years of QE had caused a misallocation of capital across the world, while the end of QE last year triggered a dollar rally with consequences that were only now beginning to be realised.
“The wrong people got the capital — emerging markets countries and corporates and a lot of cyclical companies like mining and energy, particularly shale companies — and this is now a major problem for the credit markets,” he said.
Mr Burbank was speaking days after the Fed decided against raising US interest rates from their present near-zero levels, warning of “global economic and financial developments” and the damage these could do to US growth and inflation.
Emerging markets have accumulated $7.5 trillion of external debt and are acutely vulnerable to a rapid rise in US interest rates, regardless of whether they borrowed in dollars or their own currencies, Fitch Ratings has warned.
The credit agency said international markets are pricing in a much slower pace of US monetary tightening than the US Federal Reserve itself, risking a potential financial upset in East Asia, Latin America and Africa if Fed hawks refuse to bow to market pressure over the next two years.
Fitch said the Fed has signalled a rise in rates to 3.8pc beyond 2017 but investors simply refuse to believe that this will happen, with futures contracts implying rates of just 1.4pc over the same span – an unprecedented gap of 240 basis points, and one that is fraught with risk.
The US Federal Reserve risks triggering “panic and turmoil” in emerging markets if it opts to raise rates at its September meeting and should hold fire until the global economy is on a surer footing, the World Bank’s chief economist has warned.
Rising uncertainty over growth in China and its impact on the global economy meant a Fed decision to raise its policy rate next week, for the first time since 2006, would have negative consequences, Kaushik Basu told the Financial Times.
His warning highlights the mounting concern outside the US over the Fed’s potential “lift-off”. It follows similar advice from the International Monetary Fund where anxieties have also grown in recent weeks about the potential repercussions of a September rate rise.
That means that if the Fed’s policymakers were to decide next week to raise rates they would be doing so against the counsel of both of the institutions created at Bretton Woods as guardians of global economic stability.
Such a decision could yield a “shock” and a new crisis in emerging markets, Mr Basu told the FT, especially as it would come on the back of concerns over the health of the Chinese economy that have grown since Beijing’s move last month to devalue its currency.