EMERGING MARKETS: TIME TO DIFFERENTIATE
Following an almost 30% drop (in US dollars terms) between end-April and end-September 2011, the MSCI Emerging Markets (EM) equity index has been trading sideways, with no clear direction. It has since become consensual to maintain an underweight exposure to the asset class – a view reinforced by the “taper tantrum” last year, i.e. the fear that the reduction in the pace of asset purchases by the Fed would trigger outflows from emerging markets, causing sell-offs in their currencies and financial marketplaces. However, today, the case against emerging markets within an equity allocation is weakening.
Over the past three years, emerging countries have been on the wrong side of the global rebalancing process, whereby excessive investment in those economies and high exports destined for the Western world were being wound down, leading to reduced growth differentials with developed countries. This economic adjustment is now coming to an end and, with it, the de-rating in emerging-market equities relative to their developed counterparts is almost complete (chart 1). In addition, while the monetary easing cycle in the developed world is maturing, admittedly creating fears that less liquidity in the West will hurt EM, we must not overlook the fact that the tightening cycle in emerging economies is maturing as well! A well-advanced global rebalancing process, together with a maturing easing cycle in the West and a maturing tightening cycle in EM countries advocate for EM assets to be upgraded back to neutral within allocations, although we would wait for inflows to the region to intensify and momentum to build before turning overweight.
That said, the wide dispersion in EM fundamentals also calls for a high degree of selectivity. We consider three key characteristics to discern between the better and the worse : i) balance of payment fundamentals, ii) inflation and iii) exposure to the recovery in the developed world.
Regarding balance of payment fundamentals, the current account provides a fair and simple proxy for the vulnerability of an economy. As shown in chart 2, within the 16 major emerging countries, Malaysia, the Philippines and China look strong, while South Africa and Turkey are especially weak.
The second factor, inflation, is shown in chart 3. While Venezuela, Argentina and Turkey suffer from far too high inflation, others such as Poland, Colombia, Thailand, China, Malaysia, Chile, Mexico and the Philippines have very reasonable levels of price appreciations.
Finally, given the prospect of continued recovery in the developed world, and particularly the United States, we also look for those countries that stand to benefit the most from an improving global environment. As such, we rank the countries in terms of how much they export to the US alone, as well as to both the US and the EU (European Union) combined (chart 4). We then adjust that ranking for the fact that some countries have a very high commodity concentration in their export base (given our negative outlook for commodities this year, e.g. Venezuela, Russia, Indonesia, Argentina, Chile) and also for the fact that some countries are particularly exposed to capital flow volatility (as they might suffer from capital outflows when rates increase in the US, e.g. Argentina, Turkey, Russia, Malaysia, Thailand, Venezuela). The combination of these criteria shows that the countries that should benefit the most from the recovery in the US (and to a lesser extent in the EU) are Mexico, the Philippines, China, Colombia, India and Poland.
Combining all these considerations provides us with an economic fundamentals ranking of emerging countries, shown in chart 5. Of course, a valuation overlay should be applied before considering investing, as equity indices in countries like Mexico, the Philippines, Thailand and Malaysia look expensive, while they are cheap in China, Colombia, Chile and Russia, and closer to fair levels of valuation in Poland, India, Indonesia, Turkey and Brazil. Countries that are economically weak and expensive, like South Africa and Argentina, should be avoided. As a whole, among the bigger regions, (given the difficulty of investing in small markets with limited liquidity), we would therefore favor Asia, and in particular China, where valuations are cheap.