Emerging Markets: equities rocky in the short term

Emerging Markets, May 2011

In February, Bank of America Merrill Lynch put out its monthly survey of fund manager sentiment, and revealed something unexpected: emerging Asia, the darling of world stock markets since the financial crisis, was suddenly out of favour.

Attitudes towards global equities generally had never been better: 67% of the asset allocators in the survey said they were overweight the asset class, the highest in the 10 years BAML had been asking the question. Yet at the same time, the survey showed the biggest ever plunge in sentiment towards emerging market equities, with only 5% positive compared to 43% the month before.

What’s going on? Emerging markets, with Asia as their engine, have been the driving force pulling the world out of the financial crisis. GDP growth levels are high, current account balances healthy, debt levels manageable and companies growing rapidly. Asia is where the momentum is. But the survey was not a one-off outlier, instead reflecting increasingly widespread views on allocation. Citi Private Banking chief investment officer Richard Cookson, for example, in his April 12 briefing to clients, rated Asia ex-Japan equities “very underweight” relative to the previous month, encouraging the wealthy to trim allocations.

Others are not so negative, but nevertheless underwhelmed. “We are relatively cautious on emerging markets and prefer the US and Japanese markets,” says Schroders chief economist and strategist Keith Wade, who instead likes Asia as a currency rather than an equity play. Schroders says Asia Pacific ex-Japan had the biggest outflow of any equity bloc in the first quarter of 2011, at close to -4%, compared to 10% inflows in 2009. “Institutional investors have started to be more concerned over the valuation of emerging equities and this has been reflected in their reduced intention to overweight the market, as well as the significant ebb in fund flows,” Wade says.

And that, chiefly, is the point. While there are concerns about inflation in Asia, few see any major structural problem ahead; it’s mainly a question of valuations. In 2010, Indonesia’s stock market climbed 46.13%, Thailand’s 40.6% and the Philippines 37.62%. Pakistan, Korea, Malaysia and India all topped 15%.  (China, another story in every respect, suffered a 14.31% reverse in local terms, but most investors get their China exposure through the Hong Kong market, which climbed a modest but positive 5.32%.) Gains like that – in some cases, like Indonesia, to record highs – have left an inevitable sense of nearing the top. Deutsche Bank strategist Ajay Kapur, for example, says Asian equities are likely to underperform global equities in the near term. “For Asia to outperform, it would either have to see a bubble like 1993 or 2007, or see its return on equity – already at historically high levels – power ahead to record highs. I think that unlikely.”

A typical view, then, is that just because Asia has the best economic fundamentals, it doesn’t automatically make it the best place to put money today. “The best sustainable growth prospects remain in the emerging world due to their stronger structural fundamentals including current account surplus positions,” says Wade. “We expect the emerging countries to account for more than half of global growth this year and next.” The headline numbers support this very clearly. The fiscal situations in most major Asian nations are vastly better than in the developed world. “On the other hand, in terms of valuations, the discount between the emerging and developed markets is quite narrow, indicating some of the growth premium is already in the price.”At the time of writing the trailing price to earnings ratio of the MSCI Pacific ex-Japan was a multiple of 17.9, slightly above the 20-year average of 17.5. (That said, forward P/Es on Asian shares, at 12 times, are slightly below the global share average of 12.5 times, according to AMP Capital Investors.)

It’s not quite true, though, to say that valuations are the only reason money is leaving Asia. The biggest worry by an order of magnitude is inflation. “Rising inflation is becoming a major concern in Asia and other emerging countries,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors. “So far it’s largely due to higher food prices, and non-food inflation remains reasonably benign. However, with strong growth having used up excess capacity and monetary conditions remaining easy, a glow on to higher non-food inflation is a growing risk.”

Inflation is, for example, a particular worry in Indonesia, which has been fuelled by foreign inflows that in January accounted for 30.8% of all rupiah government bonds, pushing up asset prices and also raising concerns about sudden outflows. In that environment, inflation hit a 21-month high before Bank Indonesia raised rates in February, with the CPI having grown 7.02% year on year the previous month. Fitch, calling inflation “a near-term risk to economic prospects”, estimates it will average 6.5% in 2011. Fears about inflation in Indonesia are considered to be the main reason the stock market has fallen from the record highs it hit in late 2010.

Indonesia is just one example of a fear across the region that is likely to lead to further rate hikes, which dampens the prospects for stock market performance. “Further tightening is likely to be a continuing drag on the relative performance of share markets in Asia and the emerging world over the next six months, until it is clear inflation is back under control,” Oliver says. And it’s always worth remembering that in poorer countries, food inflation is not just an irksome economic barometer; if people can’t afford food, that quickly turns into social unrest.

China, too, faces inflationary fears; its most recent CPI release, while below Indonesia, showed a 5.4% year on year increase in March, higher than many expected. Deutsche expects it to peak at 5.8% in June. And China’s behaviour and performance is absolutely central to the Asian outlook story. In terms of growth, there’s little cause for alarm: expectations for growth tend to come in around 9% for 2011 and 8.5% for 2012. But that’s not the same as a positive equity story; in 2010 China’s GDP grew by double digits while its domestic stock markets fell by double digits, which is no mean feat.

One scenario, a bearish one, suggests that inflation becomes a persistent problem for China to the point that government priorities shift from growth to inflation, raising interest rates and reserve requirements significantly, triggering a hard landing, decelerating growth and a knock-on effect to other markets. Schroders outlines a case in which emerging markets growth could fall to 3.5% in 2012 if this were to happen. While Schroders only presents that as a possibility and not its base case assumption, Wade says he forecasts additional lifts in reserve required ratios and interest rates in China in the year ahead.

Others, while cognizant of inflation risk, think the picture pretty good in China. Export growth was 37.7% year on year in January and tightening measures appear to be doing what they’re meant to, with loan growth falling. Deutsche, which advises a medium weight to Chinese equities, has upgraded its forecasts for 2011 GDP growth to 9.4%.

Interestingly, some see equities as the perfect hedge against exactly the problem that is so vexing the region: inflation. Gold is normally considered the ultimate inflation hedge, but a Barclays Capital survey of Asian wealth managers – with more than $5 trillion under management between them – released in April showed that they consider local equities the best bet. There is some logic in this: commodity stocks tend to rise with commodity prices, food producers with food prices, and so on.

This wealth management constituency is clearly keeping the faith with Asia: 60% of respondents to the survey expected revenues to grow by more than 5% in Asia ex-Japan over the next two years, with China (where 54% expect 15% growth per annum or more) and India (where 40% expect that level of growth) leading the charge.

On top of worries about inflation or Chinese growth sustainability, there is always the question of how the rest of the world behaves. The idea of a decoupling between Asia and the world economy has been long since debunked – although, in truth, every year of development in Asian domestic consumption brings it a little closer to being plausible – and Asia remains vulnerable to external shocks. Chief among these are the pace of US recovery, weakness in the Eurozone (and in particular its sovereign debt issues), global liquidity tightening (money always flees emerging markets at times of stress, regardless of how illogical that might be), upheaval in the Middle East and a prolonged high oil price.

While strategists and fund managers puzzle about short term timing, longer-term attitudes are generally very positive. “Our cautious short term stance on emerging market shares doesn’t alter their favourable strategic outlook,” says Oliver. “Inflation in the emerging world is a long way from spiralling out of control, valuations are reasonable and Asian and emerging countries generally lack the debt constraints of major developed countries.”

And when fund managers look at the really long term, they get a lot more positive. “There will be 300 million more workers in Asia in the next 10 years. The labour force in developing countries will shrink over the same period,” says Kerry Series, chief investment officer of 8 Investment Partners, an Asia-focused fund manager based out of Sydney. “The Asia story is 60% of the world’s population reclaiming their share of wealth – getting back to where they have been for 18 of the last 20 centuries.”