A contrarian value case for emerging markets has slowly emerged, in our view.
The marked underperformance of emerging-market (‘EM’) assets has been a dominant feature of 2018. As of September 7, 809 out of 1,150 EM stocks are in a bear market (defined as a drop of more than 20% from their high), according to Bank of America Merrill Lynch (‘BAML’), while the Turkish equity market has more than halved this year in USD terms. EM currencies of many countries are at, or close to, all-time lows in nominal terms, including Russia, Indonesia, India, South Africa, Turkey, Brazil and Argentina.
There have been several drivers behind these moves. Federal Reserve tightening has reduced USD liquidity around the world, including through a strengthening USD and higher US rates across the curve. This is a problem for markets that rely on foreign flows and funding, including several EM markets. Note that dollar-denominated debt in EM has more than doubled to USD3.7 trillion over the past decade, according to data compiled by the Bank for International Settlements.
Meanwhile, the prospect of trade wars has been a constant threat and has increased the risk premium for EM-related assets that would be more likely to suffer from an all-out trade war through tariffs and quotas.
Furthermore, there have been idiosyncratic developments in individual EM countries that have exacerbated some moves, such as the appointment of family members as Finance Minister.
We look for potential opportunities in crises. And we believe a contrarian value case for EM has slowly emerged.
The Case for EM
We emphasise the word ‘slowly’, as from our analysis, we believe that the contrarian value case is not as extreme as it was in the late 1990s, or in late 2015, for instance. Positioning in EM equities is now about 1 standard deviation lower than its historical average, according to a September fund manager survey from BAML. BAML also calculates that EM Risk Appetite is in panic mode.
We find the same. Risk appetite for EM is now as low as its 5th percentile of historical readings, according to Man GLG’s calculations (see Figure 1). A reading as low as this has historically been followed by rising EM equities in 71% of cases and +38% on average, while the average of the losses amounted to minus 15% over the subsequent 12 months (1997 to present). These odds improve further if one takes three months later as starting point, illustrating that the bottoming process can be a volatile period. Falling knives carry dangers, after all.
Figure 1. Man GLG Risk Appetite Measure in Bottom Decile of Historical Readings
Source: Man GLG, Bloomberg. Risk appetite measures the correlation between realised volatility and returns across a range of equity markets. A low reading represents panic, a high reading euphoria. As of September 30, 2018.
Meanwhile, valuations for EM equities appear quite reasonable in our view, as shown by the relative price-to-earnings (‘PE’) and price-to-book value (‘PBV’) of EM versus developed markets (‘DM’) being just below long-term averages1. One of our favourite research contacts puts it this way – what would you rather own: US equities on 17-18x PE for about 6% earnings-per-share (‘EPS’) growth, or EM equities with Hong Kong on 10x PE and other major EMs nor far from there, for 10% plus earnings growth? Thus, EM equities may have become a contrarian value asset class, although clearly, according to these same indicators, these assets are not as much shunned as they have been at worse times in the past.
It should be noted that since the EM crises of the 1980s and 1990s – when EM countries often had fixed exchange rates and/or insufficient FX reserves – many EM countries have been keen to trying to avoid external vulnerabilities. As a result, floating exchange rates combined with increased FX reserves are now more prevalent. It can be argued that Turkey and Argentina are not representative of other EM, where their USD-denominated debt is more limited versus FX reserves and current accounts are more in balance than in the past.
Still, we believe an improvement in fundamentals is needed for a contrarian value case to start building – at least fundamentals need to get ‘less bad’ to start with. What could constitute such an improvement?
- The USD could weaken, thus providing relief. A variety of factors suggests to us that this could be a plausible scenario: Fed Governor Jerome Powell was more dovish than expected at the Jackson Hole conference on August 24; speculators’ positioning is long the USD as per the latest US Commodity Futures Trading Commission (‘CFTC’) data; and US growth has been stronger than elsewhere in the world, which, if reversed, has the potential to weaken the USD. Indeed, while we do not see the end of this economic expansion in the US, signs are that 2018 could be a peak growth year – with, for instance, the growth impulse from a growing budget deficit falling from +2.5% of GDP in 2018 to +1.1% of GDP in 2019, according to OECD data. It should also be noted that it would seemingly be in the interest of the US to embark on trade negotiations while the USD is weaker rather than strong;
- Weak EM FX may be part of the solution. Multiple studies2 have shown that historically the best moment to buy EM assets has typically been when growth is low and currencies have been weak. Indeed, weak FX and slow growth can act as stabilisers to the extent that trade deficits narrow when export volumes increase due to a weak currency and imports decrease while domestic economic activity is weaker during a domestic crisis. Analysis done by Man GLG also finds that the outlook for assets in countries where the real effective exchange rate has fallen by more than 30% in six months, has historically been encouraging3;
- Recent policy initiatives in EM have been supportive, in our view. Turkey and Argentina are hiking interest rates to defend their currency, an orthodox policy response. When policy makers start panicking, maybe markets can panic less. China has amounted to incremental easing through liquidity injections, RRR cuts and fiscal easing. These initiatives have, admittedly, been limited so far. It is also the case that China stimulus, which could be good for the world economy, ceteris paribus, could be nullified by a weakening China currency;
- Domestic demand in EM countries could improve, nascent signs of which may be detected in recent Taiwan and Korea export orders. Monthly export orders data is quite noisy and it should also be noted that economic growth in EM countries has been disappointing since 2016, despite traditionally bullish developments such as the rise in commodity prices.
All in all, our judgment is that the outlook for EM as an asset class has improved after recent price declines. As mentioned previously, bottoming periods can be volatile. In our view, the largest risk is that the trade war intensifies, perhaps in part driven by the US electoral cycle, which could provide the trigger for capitulation and potentially creating a better entry point.
1. Source: Bloomberg.
2. From Professors Elroy Dimson and Paul Marsh and Dr Mike Staunton from the London Business School.
3. Past market performance is not a guarantee of similar future results.