Emerging market equity underperformance has further to run

Emerging Markets EBRD editions, May 10 2013

The underperformance in emerging markets equities still has some way to run, according to fund managers and analysts.

Emerging market equities have underperformed their developed world peers by about 12% since the start of the year, through a combination of improving momentum in the US and Japan, and increasing challenges in the BRIC economies, particularly China.

“I’ve been negative on emerging versus developed equities, especially the US, since the autumn of 2010,” said John-Paul Smith, global emerging market equity strategist at Deutsche Bank. “For me it’s a multi-year underperformance cycle and we are, at best, halfway through it.”

Maarten-Jan Bakkum, senior emerging market equity strategist at ING Investment Management, agreed. “We are now two and a half years underperforming, and it’s quite a surprise that a lot of people are still excited by emerging markets,” he said. A continuing slowdown in China – he predicts a decline to 5% growth there within three to five years – and a lack of reform and structural change in emerging markets, certainly compared to the developed world, are “two reasons to believe emerging markets will continue to struggle,” he said.

Smith said that a weak economic environment tended to bring out bad practices. “The corporate governance side of emerging markets is relatively cyclical,” he said.  “In an economic environment which is relatively depressed, corporate governance considerations are secondary.

“We are seeing that both in the private space and in the involvement of government: you have seen several governments take actions to the detriment of minority shareholders, shifting resources away from capital towards labour and the state.” This has been most pronounced in Brazil, but there has also been evidence of it in Russia and China, he said.

Both men were bearish on China. Bakkum said: “A lot of people are counting on China growing at 8% forever. That’s strange, because growth is already at 6.6% if you annualize the first quarter.” He also said that China’s demographics are unsupportive, with the labour market shrinking; there is a sharp rise in leverage in the economy; and Chinese growth is dependent on new credit, meaning any regulation on credit will slow growth. “I have quite a high conviction call that China will have difficult times for the next three to five years.”

Both also avoid Russia. “Structurally I don’t like Russia and don’t see any reason to be invested long-term: there is no positive change, the government is intervening in the economy more and more, and in large part it is state-owned or influenced,” said Bakkum. “There are a lot of structural issues there and sentiment is very negative,” said Smith, who has been underweight Russia for two years. “In fact, when you look at the relative success of a market like Turkey, the fact that it’s not Russia accounts for a lot of that.”

Both saw Turkey as a rare relative strong point in emerging markets. Bakkum rates it as one of three large markets he takes an overweight position on, the others being Mexico and, perhaps surprisingly, India. “India has been a bad market for several years, but a lot has been digested and there is now some upside potential,” he said, noting that the government has maintained fiscal consolidation, inflation is coming down, and the trade and current account deficits have started to narrow.