DRUT Bastien , Fixed Income and FX Strategy
HERVE Karine , PhD, Senior Economist
MIJOT Eric , Head of Equity Strategy, Deputy Head of Strategy Research
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Since 2011, emerging markets have tended to underperform developed markets. This has been the case in particular since mid-2014, when commodity prices began to fall even faster. But so far this year, emerging markets have managed to weather the turbulence caused by volatile oil prices and concerns over China. In recent years, emerging markets have accustomed us to short-lived spikes. What about now? In this note we look more closely into this question, including a review of both macroeconomic factors and (currency and equity) market factors.
1- Multi-track emerging economies
Since the normalisation of US monetary policy was announced in spring 2013, emerging economies have been constantly exposed to new shocks. Economically, the drop in commodity prices that began in mid-2014, which came at the same time as the Chinese slowdown, may have benefited all end-consumers but hit net commodity exporters hard (through depreciation in their currencies, higher inflation, tightening of the policy mix, etc.). In the wake of additional (geo)political idiosyncratic shocks, Russia and Brazil look like the big losers among emerging economies with both suffering recessions of close to 4% in 2015, recessions that are unlikely to end until the (late) 2017.
Obviously, not all emerging countries have been affected the same by falling commodity prices and the Chinese slowdown. Commodity-exporting economies that had adopted hawkish monetary and fiscal policies1 (Mexico, Chili, Peru and Colombia) had room to mitigate the impact of tighter financial conditions caused by the depreciation of their currencies, unlike Venezuela and Brazil, for example. For net commodity-importing countries, particularly Asian ones, lower commodity prices have helped offset the impact of the Chinese slowdown to such an extent that most of these countries’ growth in 2015 was about the same as in 2014. Central Europe, meanwhile, benefited from both lower commodity prices and a strong German economy. All in all, GDP growth in emerging markets shrank by about one percentage point from 4.8% in 2014 to 4% in 2015. While all regions were hit by slower growth, there were still some wide divergences. For example, while emerging Europe and Latin America turned in slightly negative growth rates, Asia expanded at almost 6%. Keep in mind, however, that there were also wide differences between countries within the same region.
Countries do not differ on the basis of growth criteria alone. Central bank monetary policies have also been tightly restrained by the international economic environment. Whereas net commodity-exporting countries have had to raise their key rates to varying degrees, in reaction to pressures on their exchange rates and domestic inflation, Asian and Emerging Europe countries have begun monetary easing cycles due to de/disinflationary pressures from the euro zone, as well as China.
The resilience of major economies (United States, the euro zone and China) should provide some support for emerging economies. First of all, in advanced economies, the euro zone and the United States in particular, economic indicators are relatively reassuring, even if they still point to soft growth. In the US, job market figures in particular calmed the markets, and a recession appears to be less likely. Moreover, US rates are likely to be tightened less than had been expected a few weeks ago (the median Fed Fund projections of FOMC members is now just two Fed funds hikes in 2016, down from four at the December FOMC meeting). Emerging economies, whose financing conditions have worsened considerably since 2014, are expected to be less constrained in terms of monetary policy, which will provide a boost for these countries. In the euro zone, in addition to economic indicators, the ECB’s 10 March announcements were well above the markets’ expectations, in contrast with after the Council of Governors’ meeting last December, and that should make it possible to stabilise growth in the euro zone. Moreover, measures announced by the Chinese authorities reinforce the premise that China is likely to avoid a hard landing. And, regarding oil, February discussions between producing countries (while not resulting in any concrete agreement) at least prevented a further drop in prices.
All these factors have helped lower risk perception and make risky assets more attractive, including emerging assets. However, while global uncertainty has receded and risk perception has declined, it’s best to remain cautious. In Europe and the euro zone (geo)political risks (terrorism, political instability in peripheral countries, the migrant crisis, and a possible Brexit) could undermine growth if they were to last and/or gather in strength. In the United States, while a recession is quite unlikely, manufacturing figures point to downside risks. In China, the authorities are clearly trying to switch growth models without major disruption, but any transition process is inherently uncertain and the risk of an incident can never be ruled out. Meanwhile, commodity-exporting countries and some Asian countries closely integrated with China have not begun or completed their own process of adjusting to more diversified production models. With commodity prices likely to remain low for a long time to come and with demand relatively sluggish, it will be even more difficult for these countries to carry out the reforms they need, in order to stabilise growth in the medium term.
1 Compliance with central bank objectives regarding, inflation or currency targets and implementation of fiscal rules aiming in particular to save commodity-driven surpluses when commodity prices are above the official equilibrium price and vice versa.
2- Emerging currencies awaiting confirmation
Over the past few quarters, the relative performance of emerging currencies vs. developed economy currencies has been steered mostly by the dollar-renminbi exchange rate (USD/CNY). In particular, the speeding renminbi depreciations of August 2015 and January 2016 triggered a steep underperformance by emerging currencies. These shifts should be viewed against a backdrop of an overvalued renminbi. The dollar’s run-up since mid-2014 (+25% in effective terms between mid-2014 and January 2016) sent the renminbi up sharply in effective terms, an appreciation that the Chinese authorities could no longer tolerate and that led them to devalue the renminbi vs. the dollar. The fact that the US dollar’s effective exchange rate probably peaked in January lessened the Chinese authorities’ temptation to suddenly devalue the renminbi, which is good news for emerging currencies.
Meanwhile, a number of emerging currencies are now steeply undervalued, in particular oil-driven ones like the rouble, the Mexican peso, and the Malaysian ringgit. The oil price rally should provide them with a boost, albeit one that is likely to be slight, slow and erratic. Globally speaking, the decline in risk perception so far this year has driven up emerging currencies, particularly those currencies that had been hardest hit in 2015. In Q1 2016, the Brazilian real and the Malay ringgit performed most strongly against the dollar (about +7%), followed closely by the rouble (+5.5%).
We believe other catalysts will be needed, particularly some reassuring signs on growth, if the rally in emerging currencies is going to last. We are overweighting some high-interest-rate currencies, such as the rouble and the Indonesian rupiah and continue to underweight low-yielding Asian currencies (KRW, TWD, THB, and SGD).
3- Emerging equity markets: a tactical or cyclical rally?
Emerging equity markets have outperformed developed markets so far this year, driven recently by three powerful catalysts: the rebound in oil prices, the halt in the dollar’s rise, and the renewed lustre of the “undervalued stock” theme. The rally has even been fed by some inflows in recent weeks. What should we make of this?
In terms of flows, Emerging markets have experienced net outflows of the past four years, thus wiping out most of the net inflows from the start of 2009 to the end of 2012. In terms of cumulative flows since 2009, of the 200 billion dollars that had been invested in this asset class, only 50 billion dollars remain today. So the purge has been severe and portfolios are unlikely to be overweighted in emerging assets. So there is some upside potential if confidence continues to return, which will go hand-in-hand with an improvement in fundamentals.
In terms of valuations, the price-to-book value (1.42x based on MSCI data) has returned to a level comparable to March 2009 and March 2003. RoE, meanwhile, has fallen from a peak of 17% in 2008 to 10% today. PBV does remain higher than its low of September 1998 (0.92) or even October 2001 (1.24). In relative terms compared to developed markets it is just below its 10-year average (0.65 vs. 0.77) and about twice as high as in September 1998 (0.31). As with inflows, there is therefore clear upside potential in emerging markets, but they are not undervalued enough to justify a return to this asset class with a cyclical outlook.
The key to a cyclical rally can be found in profits. The 35% decline in profits since 2011, based on the IBES 12-month trailing earnings, has accelerated since 2014 and the drop in commodity prices. No wonder these markets reacted positively to the oil price rally and the initial stabilisation of industrial commodity prices. Assuming that this trend stays on track, as occurred in 2012, there will still be the issue of corporate deleveraging.
Pending greater clarity on whether the rally is cyclical, we feel it is reasonable not to underweight these markets
Currency devaluations have, in turn, boosted the US, Japanese and European equity markets. It would be normal for emerging markets to have their turn. As these less liquid equity markets tend to move in the same direction as their exchange rates, they are more volatile and dependent on inflows.
Weak investor exposure may point to a rally. Low valuations would suggest longterm potential. But conditions are not yet right to have a strong conviction on a rapid return of profits.
Of course, the markets will price this in and forex market trends should provide us with precious data. A divergence occurred in 2014 (falling currencies and rising share prices). Equities ultimately turned around and followed currencies downward. If this trend were to continue, this time upward with exchange rates, that would be a good sign, especially as currencies have faithfully anticipated RoE trends both upward and downward since the start of the 2000s.
Emerging markets have held up well so far this year. The stabilisation of oil prices and the topping off of the dollar have been powerful catalysts, especially as these markets – both currencies and equities – were oversold and inexpensive. However, economic fundamentals remain very shaky and caution is still in order. The rebalancing of the Chinese economy towards more consumption is a slow process and corporate deleveraging has only just begun.
If these conditions are met, emerging markets could well be the positive surprise of 2016.
Not all emerging countries have been affected the same by falling commodity prices and the Chinese slowdown
The resilience of major economies (United States, the Eurozone and China) should provide some support for emerging economies
Measures announced by the Chinese authorities reinforce the premise that China is likely to avoid a hard landing
A number of emerging currencies are now steeply undervalued
Emerging markets have experienced net outflows of the past four years, thus wiping out most of the net inflows from the start of 2009 to the end of 2012
Emerging markets could well be the positive surprise of 2016