EM equities: end of the bear market or another false dawn?
Despite persisting long-term concerns over the Chinese economy and July’s failed coup in Turkey, emerging-market equities have rallied sharply in recent months, says Will Ballard. Can it last?
After nearly five years of relative underperformance, EM equities have recovered sharply in recent months. Receding expectations of US rate hikes in 2016 and a recovery in commodity prices have helped fuel the turn in sentiment. Growing political risks in the developed world, including those sparked by June’s UK vote to leave the European Union and the upcoming US election, may also be a contributory factor in the recovery of the asset class.
However, given a history of false dawns and significant challenges of its own – highlighted by the ongoing concerns over Chinese debt and the recent coup attempt in Turkey – Will Ballard, Head Emerging Market & Asia Pacific Equities, took part in a Q&A to assess whether the rally is sustainable.
What has triggered the change in sentiment to emerging markets?
Will Ballard: The dual concerns over the Chinese economy and tighter US monetary policy weighed on emerging market shares throughout 2015. After an initial false start there were clear signs that both risks could abate.
In March it became increasingly clear that the Fed would take into consideration more than just domestic factors when assessing its future monetary policy. This contributed to it adopting a more dovish stance, delaying an inevitable increase in interest rates and helping stop the dollar from appreciating further. A stronger dollar has historically been a significant headwind to emerging-market economies. A weak dollar, however, allows them some flexibility to lower rates, increase credit and stimulate domestic growth; creating an attractive environment for a resurgence in corporate earnings.
Fears around Chinese growth also started to ease. In January we saw the authorities inject additional stimulus to prop up the economy and meet their target of 6.5-7.0 per cent annual growth. This was followed with the Chinese National People’s Congress meeting in March. The clear message was that authorities would prioritise growth over deleveraging or structural reform. This can be seen clearly from the spike at the start of the year in total social financing (an indicator of credit creation) and new loan formation.
While total debt to GDP remains too high [it hit had already hit a record 246 per cent by the end of 2015] , increased loan growth and infrastructure spending in recent months means the near-term risks to Chinese growth have receded. Having the world’s second largest economy fall back on its traditional growth model of credit and fixed asset investment cannot be done without global impact. Commodity prices, such as iron ore (which feeds into steel and so Chinese infrastructure demand), have picked up too.
Unsurprisingly, the combination of these factors has meant the outlook for emerging-market growth has started to improve.
Do developed markets currently face larger risks that emerging ones?
WB: Emerging markets are perceived as deserving a greater risk premium than developed ones due to the higher risks surrounding the nature of their political institutions. This perception is often justified. Thailand had a recent referendum and is ruled by a military government; there was an attempted coup in Turkey in mid-July, and President Dilma Rousseff is in the final throes of being impeached in Brazil.
Brexit and the upcoming US election, have challenged the perception that developed markets are immune to such risks. Though this does nothing to change the risks associated with emerging market politics, the change in perception and their relative attractiveness to developed markets has certainly improved.
Taking Brexit as an example, the leadership of the incumbent UK government dissolved in the immediate aftermath of the vote before a new leader and cabinet emerged, but the democratic process and institutions stayed in place. By contrast, the referendum in Thailand was a step towards the military government becoming part of its democratic institution.
What are the main risks in emerging markets?
WB: China remains one of the main risks. There is a question over how long policymakers can sustain current growth rates before implementing much-needed reforms. There were signs they were experiencing a modicum of success rebalancing the economy towards a more consumption-driven model of growth. However, the acceleration in credit growth - though it supports growth in the near-term - brings forward the day they must deal with the excessive credit and structural imbalances in the economy. You can see the effects of credit growth in the spectacular increase in house prices in tier one cities; and yet we can also see an increase in credit defaults this year and rising challenges facing legacy industries such as coal mining, iron ore, coal and steel, despite buoyant commodity prices.
In Brazil, President Rousseff’s potential impeachment trundles on. Michel Temer’s interim government has managed to push through some reforms but the window for further changes is narrowing. There are signs growth is now stabilising, with the GDP only contracting marginally in the first quarter after one of the deepest recessions the country has experienced. The economy has, however, yet to show the signs of robust growth that would justify the 50% rise the Brazilian equity market has experienced since January.
Turkey is still a concern for the reasons I’ve mentioned. We see well-run companies trading at a significant discount in Turkey, but that discount is there for a reason. Rather than any knee-jerk reaction following the failed coup, we want to see how it plays out and try to understand the implications for the longer term.
Mexico is sensitive to the outcome of November’s US election. The peso has weakened substantially and failed to participate in the rebound seen in many emerging-market currencies this year. They’ve recently increased rates in an effort to put a floor under the currency. Despite the high level of Mexican exports bound for America, domestic shares still look expensive. Much of the pain has been taken through the weaker currency. Manufacturing looks most at risk from a correction, as do consumer spending-driven businesses.
Which emerging markets are you more positive on?
WB: The Indonesian rupee has stabilised and the country’s central bank has been able to lower interest rates. The government is pushing through a tax amnesty that is likely to bring more assets and investment back on-shore. Domestic credit growth is improving and support for President Joko Widodo’s coalition has grown; opening the door for further economic reforms.
India is another positive. After poor monsoons over the last two or three years, this year’s monsoon has shown significantly more promise. This should boost rural growth and consumption in the country and, as a consequence, GDP. A change to the tax system, unifying state tax differences, is the latest business-friendly reform and a sign that things are moving in the right direction.
Russia is an interesting case. Domestic growth has stabilised as the oil price has recovered and much of the economic pain has been taken through the currency. The outlook is looking slightly more positive; however, this must be placed in the context of recent signs of deterioration in the Ukrainian conflict.
Across the emerging-market universe, valuations remain cheap at around a 30 per cent discount to those in developed markets. The big question is what the situation will be like in a few years’ time.
Are emerging markets likely to outperform developed ones again?
WB: Sentiment has definitely improved towards emerging markets. Both economic growth and corporate earnings have also shown signs of stabilisation and are now picking up after a very tough 2015.
This should all be put against a backdrop of equity market valuations. Though we do not believe valuations provide a catalyst, they can provide a foundation to strong returns once the catalysts are in place. At this time, US equities have recently hit record margins; valuations look stretched and multiples are high compared with the historical average, while shares in emerging markets trade at a very material ‘discount’.
There is definitely the potential for the discount between the two regions to narrow significantly. We could see a discount of 10-15 per cent for emerging-market equities relative to developed markets, but are unlikely to see a return to the premium emerging markets traded at prior to 2008 until we finally see China embrace the need for structural reform.
 Bloomberg, 31 Dec 2015
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- The UK’s shock vote to leave the European Union was a strong positive catalyst for emerging-market sentiment
- The 30 per cent emerging-market equities discount to developed ones may narrow to 10-15 per cent in the medium term
- While total debt to GDP remain too high in China, increased loan growth and infrastructure spending in recent months means the short-term downside risks to Chinese growth are falling
- A surprise slowdown in Chinese growth or tightening of US monetary policy are key downside risks.