Where are we now? Looking for value in Emerging Markets after the recent rally

 

MARCH 31, 2016 [Emerging Markets, Economy]
Charles Wilson, PhD


After a rough start to the year the MSCI Emerging Markets Index is up sharply – What's next?

Through January 21st, the MSCI Emerging Markets (EM) Index was down 13.29% YTD. That was the second-worst start since the inception of the index in 1988, behind only the poor start of what turned out to be a dismal year in 2008. Many pundits had called for further weakness in 2016, despite the tough end to last year, as U.S. interest rate policy normalized. The expectation was that further dollar strength would lead to additional pressure on emerging market currencies and potentially drive defaults on external debt held across emerging markets and more specifically among stressed commodity producers. We noted in several previous posts that the outlook for emerging markets and their equity returns really hinge on the dollar, which remains tied to U.S. interest rate policy and more specifically market expectations for near-term rises in the Federal funds target rate. It has been clear that aggregate expectations for U.S. interest rate policy expressed by the Fed through its "dot plot" continued to contemplate a different economic reality than that expressed by the market via fed funds futures. Market expectations were more negative regarding U.S. economic growth and the impact from a still weak global economy, leading market participants to lower their expectations for future rate hikes. The January Fed meeting was the first clear recognition that the Fed was moving toward market expectations rather than vice versa, giving the dollar bears some fuel for their fire. Perhaps in a somewhat coordinated effort, central bankers in Europe and Japan also took additional steps to boost economic growth, but not by pulling the interest-rate currency lever as they had under previous policy initiatives. Instead, they have shifted their focus toward credit easing and targeted asset purchases to spur risk taking instead of broad-based increases in the money supply through low or increasingly negative key policy lending rates. The combination of the two led to an abrupt selloff in the dollar and a rally in all risk assets that had previously been depressed by dollar strength. Targeted easing is the new black and dollar shorts are the corollary.

Risk Assets Rise on Dollar's Fall, Change in price January 21-March 30, 2016

Source: Bloomberg

 

If we look at the performance of a cross section of emerging markets in dollar terms before and after the January 21 trough in the MSCI EM Index, as well as year-to-date, it’s clear the strongest markets have seen the most benefit from dollar weakness through their connection to the commodity complex and a more fragile external funding situation. As we predicted previously, a stabilization in the dollar or a rally in EM currencies would pave the way for dollar-based earnings growth, which is something that has been missing for the last few years. The Fed's decision to shift to a more dovish policy stance gave investors a taste of what a stable-dollar world would look like for emerging market investors.

Emerging market Forward Earnings Growth

Source: Bloomberg

 

Before and After January 21, 2016: MSCI Country Index Net Returns

Source: Bloomberg

 

As you can see from the chart above, most markets have bounced a long way from their January lows and in some cases are posting very strong dollar returns year to date. Broadly speaking, emerging market valuations are still well below their developed market peers, but are at the high end of their long-term historical range based on price-to-earnings multiples. The blanket "emerging markets are cheap" statement no longer seems to apply, especially when you consider there is still scope for further earnings downgrades in some major emerging markets such as Brazil and perhaps India and Thailand. But the index is diverse and the answer to the valuation question is more nuanced. If you look at the equity risk premium (current earnings yield minus the long-term average risk-free rate), you can see several of the markets are showing negative premiums currently. We acknowledge that certain high-inflation markets or markets with large sources of trapped capital (domestic pension funds) consistently exhibit negative equity risk premiums. However, even those markets are more negative than normal. The most risky currencies in several cases are in countries with the most uncertain political outlook, and are trading at the largest premiums relative to history and their local risk-free rates. Several northeast Asian markets, on the other hand, still appear attractive, at least on a country valuation level. The performance differential between many Asian markets and the more fragile markets probably has to do in part with the extreme short-positioning related to concerns over dollar strength and some momentum chasing once the short-dollar unwind began.

Various Country Risk Premiums in Negative Territory

Source: Bloomberg. Earnings yield derived from country MSCI data, and local risk-free rate based on local 10-year treasury bond.

 

In hindsight, the selloff to start the year was precipitated by continued dollar strength and a concern of multiple (up to four) Fed rate hikes over the course of 2016. While expectations for the extent of hikes in 2016 have eased, it's worth noting that is in part due to concerns about global economic growth and the impact of reduced dollar liquidity on that growth. That's not necessarily bullish for emerging markets. Global trade is still important to many developing countries, especially in Asia. Roughly two-thirds of the constituent weights of the MSCI EM Index are domiciled in countries with current account surpluses driven by economic models based on exports. The export model built on global trade and driven by increased consumer leverage in developed markets has run its course, and that is reflected in the current state of lackluster global trade growth.

Country Current Account Balance and MSCI EM Weights As of 12/31/15

Source: Fact Set

 

Global Trade Volume Growth

Source: World Trade Organization

 

This leads to the question: What are emerging markets without a global trade tailwind? To us, this is where things get interesting. Strong global trade is great for animal spirits and broad-based equity returns, but it's also a rising tide that lifts all boats. There were a lot of low-return, capital-intensive business models that survived on excess returns produced in a synchronized global growth environment. Stock picking in emerging markets was to some extent a blindfolded dart-throwing competition, particularly over most of the decade starting in 2000. Today, the tide remains out, in our view, but that does not mean there aren't great businesses, which will increase their value over time in dollar terms. We think the more interesting companies are those with dominant market share and low capital intensity and are located in a stable domestic market with long-term penetration opportunities. The opportunity for those companies remains, regardless of U.S., European and Japanese monetary policies.

So where are we? The recent run has been strong and has pushed valuations back to normal levels relative to history in some markets, especially those most impacted by the strong dollar. Parts of northeast Asia still seem to be showing some discount to historical metrics and peers, although weak global trade growth remains a headwind for the region. We still believe we are in a slow growth world where earnings certainty will be rewarded over potential earnings growth, even more so now after we have seen our margin of safety erode for the more fragile markets. The preference for earnings certainty has been reflected over the last few years in the quality premium noted by many market observers, a premium that is greatly diminished following the recent rally. The future remains uncertain and binary in nature. Looking forward, we will continue to try to construct portfolios filled with businesses that we believe will continue to outperform in a variety of macro-economic scenarios.

The performance data quoted represents past performance; it does not guarantee future results.

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