Emerging markets have been hammered by recent tapering of the U.S. Federal Reserve’s quantitative easing program, which has hit both currencies and equity valuations as investor money has sloshed back into the developed world, specifically the U.S. markets.
Savvy investors need to ask how long this shift will last given some pretty strong fundamentals for select economies in the developing world and some signs that the vaunted U.S. recovery is not as strong as expected.
Emerging markets investment firm Ashmore Investment Management argued last week that the groundwork, in the form of five conditions, has been laid for an emerging markets turnaround.
The so-called hot money of retail investors that poured into those markets in 2012 and much of 2013 has left (at a loss, mostly). The firm also expects emerging markets economies will pick up this year, achieving an average 5-per-cent growth rate. Third, investors need to get used to the bad news from the likes of the “Fragile Five,” which have made the tough moves such as raising rates and devaluing. “None of these countries have a crisis per se, meaning unsustainable debts, running out of reserves, experiencing collapsing banking systems, or suffering wholesale corporate defaults,” the firm stated. The final condition? That investors recognize the opportunity cost of not being invested has to be painful.
Ashton doubled down on its emerging markets call this week, declaring, “There is far more value than crisis in EM, even if denial seems to be the order of the day,” as the U.S. Fed and Bank of England edged closer “to openly admitting that they intend to inflate away their country’s debts as they retreated from previous commitments to tightening monetary policy in the face of falling unemployment.”
Once that becomes widely acknowledged, it expects investor sentiment to turn decisively positive for emerging markets.
While Ashton says picking a definitive date for a turnaround “is a fool’s game,” it highlighted hopeful signs, such as a surprise from China in the form of moderate inflation for January and a sharp rise in exports. It attributes that to a bounce back in the emerging markets and in Europe.
There is a strong argument to be made that the crash in emerging markets valuations has far more to do with sentiment than fundamentals, and that it could similarly turn the other way just as quickly.
“If you look back at sort of every time there is an EM crisis, it is usually a hot-money-flowed-in, flowed-out kind of thing,” says Darren Sissons, a managing director of Portfolio Management Corp. of Toronto.
The New Zealand-born investment manager loves emerging market growth fundamentals, particularly those of Pacific Rim countries. “These countries are still growing at elevated rates relative to North America. A lot of money is flowing to the U.S. to chase this cyclical recovery. How do you get excited about 2-per-cent growth?”
China, by comparison, is down from its double-digit growth heyday but is still enjoying world-beating expansion compared to most countries. “I don’t know why the world is getting so excited about China on the negative side; it is still growing by 7 per cent.”
For investors who want to get ahead of an emerging market turnaround, Mr. Sissons recommends they focus on quality. “You want to start thinking about, let’s call it, developed Asia that has strong fiscal and macro positions. So that would be companies that generally run balance-of-payments surpluses, so they are big exporters.”
On a country basis, that is companies in South Korea, Taiwan, Hong Kong, China and Singapore. “These countries would be definitely safe havens,” he says. “China is less developed, but it has a higher growth rate.”
He likes banks, real estate and industrial companies in places such as Singapore and Hong Kong and “staple” companies for faster growing economies such as China. He advises that investors wait for more definitive signs of an emerging market turnaround before getting into countries such as Indonesia and the Philippines.
He is less optimistic about the short-term prospects for Latin American countries which, like Canada to an extent, are a commodity play. Beyond an unfavourable commodity cycle, “some of the countries in Latin American have very poor macro governance” such as high inflation, questionable official economic data and unfriendly shareholder jurisdictions in select cases.
Mark Lin, a Montreal-based vice-president and portfolio manager of international equities who runs the CIBC Asia-Pacific fund, noted that BRIC nations (Brazil, Russia, India and China) and other Pacific Rim countries were trading at a premium. “Right now it is just the opposite.” His fund, which holds investment positions in companies based in China and Indonesia, is most bullish on Indonesia. It owns stakes in two Indonesian consumer banks that stand to benefit from that country’s demographic trends.
“Countries don’t change overnight but the fund flow, the capital flow, of investors was really spooked by [the prospect] of higher interest rates and less money printing, bond-buying behaviour” of the U.S. Fed.
That retreat of investors from emerging markets has made some countries, industries and individual companies bargain-priced, but people need to be very selective coming back in, as there is no guarantee that emerging markets will roar back as quickly as they faltered, Mr. Lin says.
“We think the pullback provides opportunities only in certain markets.”