A (not so) surprising emerging markets rally
March turned out to be a fantastic month for emerging market assets. Almost everything moved higher, and the MSCI EM equity index gained 13%, driven by currencies, commodities, flows and markets like Brazil, Turkey and Russia in particular. Some off-index markets did even better, with the China A-shares market outperforming by 14%.
This spectacular performance may seem counter intuitive, given the predominantly negative political backdrop in many of the above-mentioned markets, combined with the entrenched concerns about emerging market macro in general, and emerging market (EM) debt in particular.
However, we are not surprised, as this development is in line with the out-of-consensus calls we made in our yearly outlook, a few months ago. The start of the year was arguably difficult – and we got a lot of pushback during the first two weeks of January – but things started to turn around in the second half of January, and the developments in February and March have solidified this positive trend.
Some analysts have become more constructive on emerging markets lately, whereas others are arguing that the rally will run out of steam soon. We agree that markets are unlikely to stay in rally mood, but we remain upbeat about emerging markets and thought it would be worthwhile to reiterate and update the points we made in the outlook.
- Our first point was that emerging markets had not wasted the crisis, with most EMs already having adjusted their balance sheets and currencies. EM currencies have overall performed this year, and the Financial Times (which was one of the institutions being very negative towards the asset class as recently as mid-January), wrote that EM fx had its best month in more than four years, with the JP Morgan EM currency index gaining over 5% in March.
- The second point was that emerging markets simply offer the most attractive value, growth and yield combination. That remains true even after the rally. Emerging markets currently trade at a 27% discount to developed markets on 12-month forward consensus on P/E multiples and at as much as a 60% discount on respective PEG ratios. Emerging market dividend yields remain higher than in developed markets in general, but this has more market-specific reasons. We are particularly excited about Russia, which had the highest dividend yield going into the year and where discussions are ongoing about a mandatory increase in the payout ratio from 25% to 50% for state-owned companies. An increase in payouts from the large state-owned enterprises could bring the market dividend yield from 4.8% to 6-7%.
- We also argued that the EM/DM growth ratio would re-accelerate in 2016 and that this historically has been a trigger for relative EM equity outperformance. We obviously do not know where growth will end up in 2016 or even in the first quarter, but 4Q 2015 growth was overall stronger than expected, especially in emerging Europe. Moreover, the (in our view exaggerated) fears of a sharp slowdown in China have been dispelled on the back of PMI data and official growth targets.
- Finally, and perhaps most importantly, we believed that the US rate hike was supportive for emerging markets’ equities, as long as the process is gradual and combined with stimulus elsewhere. This lower-for-longer belief has been confirmed by the increasingly accommodative policies of the ECB and dovish statements by the FED. And the weak data out of Japan suggests that the BoJ will do more rather than less in terms of stimulus in the near future.
All is not fine though. We remain concerned about the political development in places like Poland and Turkey. We still see a need for currency adjustment in markets like Nigeria and Egypt. And a number of economies, not least Russia and Brazil, need to get serious about structural reforms in order to revive economic growth.
Meanwhile, the reformist governments in India and Indonesia need to start to actually implement reforms. And China has to tackle its corporate debt burden in a credible and decisive way. These issues are all very serious but tend to be market specific rather than generic – and they tend to matter less during periods of rising risk appetite. However, investors that want to remain underweight or that want to find an excuse to sell can always refer to these factors.
Marcus Svedberg, chief economist at East Capital