Will the monkey smile on emerging markets in 2016?

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The International Monetary Fund (IMF), in its spring ‘World Economic Outlook’ entitled “Too slow for too long” slashes its world GDP growth forecasts to 3.2% in 2016 and 3.5% in 2017. However, the report also suggests that emerging market equities could outperform their developed market peers this year. Here we take a closer look at this notion.

First, the IMF projects real and nominal GDP growth to pick up faster in emerging economies than in developed ones from late 2016 onwards. The growth differential between the two zones, which narrowed from slightly more than 6% in 2009 to roughly 2% last year, was one of the main factors that caused emerging market equities to underperform their developed peers. A widening growth gap, though modest, should thus support the former versus the latter (exhibit 1).

Exhibit 1: Real and nominal GDP growth gap of emerging markets to developed markets

real and nominal gdp growth em to dm

Source: Thomson Reuters, as at 9 May 2016.

Second, rather moderate growth and subdued inflation in developed markets give substance to the view that monetary policies in developed economies will remain very accommodating. In the US, the IMF sees annual inflation growing by just 1.5% on average by 2017 from a meagre 0.8% in 2016. In Japan and the European Union it projects annual inflation to grind, very slowly, higher to slightly more than 1% in 2017, thus remaining well below the respective central banks’ targets. The message here is that there is no strong rationale for a noticeable increase in developed market yields or the US dollar, i.e. funding costs for emerging markets are not likely to deteriorate much from their current levels, if at all. This is all the more likely as global liquidity should remain plentiful, making the search for yield crucial now that yields for core sovereigns are negative or close to zero, while having moved to appealing levels in many of the emerging markets. Argentina is a good example of this unabated thirst for yield. The country’s first sovereign USD 16.5 billion issuance in more than a decade in mid-April was the largest emerging market debt sale on record and was four times oversubscribed!

Modest recovery of commodity prices should support EMs

Third, commodity prices, particularly those of crude oil, may well have seen their lows. Of course, against the background of overcapacity and substantial inventories, any fundamentally justified increase in commodity prices will likely be slow and volatile. Yet in many sectors, notably crude oil, experts are gradually becoming more positive. The International Energy Agency (IEA) believes the oil market could balance out in the second half of 2016 as global demand rises and US output is increasingly cut (IEA Oil Market Report, 14 April 2016). The latest Bloomberg consensus forecasts also suggest base metals and agricultural prices should bottom in the second half of 2016, although their recovery will likely be highly volatile and only gradual. Despite the share of commodities in emerging stock markets now being around 11% compared to just over 30% a few years ago, even a modest positive momentum on commodities would in our view provide strong support for the asset class in general, and for commodity exporters in particular (exhibit 2).

Exhibit 2: Comparison of the performance of commodities (represented by the Bloomberg Commodity Index) and different regional emerging market equity indices

commodities and emerging equities

Source: Thomson Reuters Datastream, as at 9 May 2016.

Fourth, economists and the IMF have revised upwards their forecasts for China’s GDP growth. The IMF now believes that China will grow by 6.5% in 2016 and by 6.2% in 2017, 0.2 percentage points more than in its January forecasts. These upward revisions should come as no great surprise. The details of the 13th five-year plan revealed that China will prioritise growth over reforms for the next few years, with the target of expanding the real economy by at least 6.5% each year until 2020. As the massive credit expansion, the significant fiscal boost and the softer monetary policy prove, Beijing is prioritising meeting whatever the cost for future growth, a policy whose effects are starting to show up in activity data. China still has to address the question of unsustainable debt leverage, with funding tensions in the corporate sector already starting to materialise. But in the absence of any exogenous shock, China still has enough ammunition to postpone painful deleveraging and difficult reforms until “better times”. Against this current backdrop, and with capital accounts still reasonably well under control, fears of the renminbi depreciating strongly have also dissipated. In short, the China factor is no longer playing adversely on the asset class.

Signs of better earnings momentum

Fifth, there seem to be tentative signs of emerging market earnings growth momentum turning for the better and moving more in line with that in developed markets (exhibit 3). The gradual closing of the profit growth gap between DM and EM looks more likely than at any time since the Global Financial Crisis, particularly since monetary and budgetary margins of manoeuvre are overall much greater in emerging economies than in developed ones.

Exhibit 3: Relative forward earnings of emerging markets to developed markets

forward earnings em to dm

Source: Thomson Reuters Datastream, as at 22 April 2016.

Finally, we do not believe that valuations alone can drive a market, at least not over a short to mid-term horizon, unless they are at extreme levels. But the fact that emerging markets are still at a notable valuation discount against DM is certainly helpful if the momentum towards the still under-owned asset improves – as, indeed, is currently the case, the momentum triggers being the factors highlighted above. According to Institute of International Finance, calculations (March 2016 EM Portfolio Flows Tracker and Flows Alert, 29 March 2016), estimated non-resident portfolio flows to EMs surged to a 21-month high of USD 36.8 billion in March, following a USD 5.4 billion inflow in February, with both bonds and equities witnessing sizable inflows. Interestingly, all EM regions attracted inflows in March, with Asia’s USD 20.6 billion leading the pack.

There are risks, but most EM governments are addressing them

Of course, there are risks to the view expressed here. The US dollar, for instance, looks technically oversold. Against the backdrop of an improving dataflow in the US, there is thus a good probability of a short-term rebound of the greenback, which would weigh on commodity prices. More worrying is the very rapid build-up in Chinese private debt, which has almost doubled in the last 10 years and has accelerated markedly in the last few months. While we do not believe this will lead to a hard landing, it is certainly likely to impair growth once the necessary deleveraging starts. Meanwhile, fears of the devaluation of the Chinese yuan could re-emerge. Also, a sudden rise in core yields, notably in the US, would undoubtedly derail the above scenario.

However, the positive point is that most EM governments are aware of these risks and are doing what they can to prevent them. They are building up their currency reserves, buying back external debt, tackling non-performing loans, and many are actively implementing structural reforms – all of which are just as important for the market direction as the other supportive factors mentioned above.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

Patrick Mange

Head of Investment Strategy for Emerging Markets

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