Brighter and greater focus on EM fundamentals – Ashmore’s Dehn comments

Improving fundamentals and attractive valuations will drive positive trends in emerging markets, according to Jan Dehn, head of Research at Ashmore.

We firmly believe that EM growth is likely to be stronger in 2014 than in 2013, but shouldn’t pose major risks to price stability except in a select few countries. We think the modest slowdown in EM in 2013 was mainly cyclical.

We do not expect major shifts in external balances or inflation rates. We also do not expect big changes in monetary policy, though on balance we will see fewer cuts and more hikes in 2014 than in 2013 on account of the modest pick-up in global activity. There are far larger shifts in EM macroeconomic fundamentals further down the line once inflation returns in developed economies. Currency adjustments will inevitably follow.

While we expect every region of EM to grow faster this year than in 2013 there will (as always) be strong country variations within each region for several reasons; firstly, the vast bulk of reformers will be in EM. Others will follow in 2014. Secondly, other countries will do battle with the consequences of their insufficient reforms. Thirdly, there are a significant number of EM elections due in 2014.

We think the elections in India, Turkey, and Indonesia have the greatest potential to usher in broader economic reforms in the post-election period, but we do not rule out positive developments in Brazil and South Africa depending on how the political chips fall. By contrast to EM, we expect very little in the way of reform in the developed world in 2014.

More favourable market technicals
Positioning in EM fixed income markets has dramatically improved since the start of 2013. This bodes well for performance in 2014 once sentiment changes. The technical position in EM equities is also significantly stronger at the start of 2014. The asset class saw net outflows in 2013 due to concerns about a hard-landing in China (which never materialised), the Eurozone sovereign debt crisis (which were materialised), and Fed tapering (which did not derail EM fundamentals).

We believe there is more room on the upside through positive earnings surprises and as a result, the large moves we experienced last year are behind us. We are already seeing improving sentiment towards China and with valuations across EM equities at historic lows, taking a valuation approach makes sense to maximise on the mispricing opportunities in the market.

Tail winds from the global backdrop
The global backdrop in 2014 is going to be broadly supportive for EM. We expect fewer immediate tail risks in developed economies, though developed countries continue to pose the biggest risks to investors due to their large debts, inflationary policies, and inability to reform.

EM sentiment will be impacted by the Fed’s efforts to taper via the US treasury market. Bond vigilantes will likely take on the Fed again by shorting Treasuries and thereby posing a threat to the housing recovery. The US stock market would find it difficult to rally in such circumstances, and could adjust sharply lower at some point. We also think the US economy remains fragile, because it is not anywhere near fully de-leveraged yet.

In Japan, we expect the reform efforts of the Abe administration to be insufficient to address deep-seated structural problems, excessive public debt, and deflation. Europe remains vulnerable on account of its insolvent banking system and excessive levels of debt in most countries. We do not think Europe’s politicians will find a solution to the question of bad legacy assets on bank balance sheets in 2014 and we think Europe’s growth recovery will be both weak and patchy. Ultimately, a weaker EUR will do little to ease the debt burden, because unlike the US most of Europe’s debt is held within Europe.

Taper tantrums – even markets grow up
We think EM markets would welcome the end of QE, which has become the single largest source of uncertainty in global fixed income markets (and uncertainty always disproportionately hurts EM). A post-QE world would be free to focus on relative value rather than speculate about QE related flows; this should strongly favour EM assets over developed market assets, in our view. We expect the US treasury market to be volatile.

Bond vigilantes are aware that the Fed cannot easily reverse its asset purchase programme via outright sales and the Fed can easily be forced to reverse its course if real rates rise too far, or even too quickly. This is because the US economy is still too indebted to handle materially higher real borrowing costs (total US debt as a share of GDP stood at 383% as of Q3 2013). This means that bond vigilantes can take on the Fed with a high probability of winning, just as it did last summer.

How will EM fare with volatile, but ultimately very gently rising US rates? Taper tantrums should prove far less onerous in 2014 than they were in 2013. Longer-term, we favour shorter duration and active trading of Treasury-sensitive assets.

Bigger role for active management in 2014
EM now comprises sixty-five vastly different investable sovereigns and hundreds of companies that issue stocks, or bonds, or both. Waning developed market tail risks are giving way to a greater number of elections, reforms, and adjustment across the EM universe in 2014. This means that simplistic risk on/risk off trading should prove less profitable than credit-focussed trading strategies. Passive management is becoming even less efficient. Active management should be applied not just credit and stock selection, but also to allocation decisions across sub-themes within the broader EM fixed income universe.

Valuations across markets and within sectors in our view must take precedence over making a broad-brushed global EM equity allocation. Stock selection is clearly important even in markets with perceived weaknesses – understanding the business and its growth outlook as well as what you are paying for their earnings stream will make the difference between winners and losers in 2014.

Global currencies – market is still too simplistic
The broader economic backdrop across G3 currencies remains one of low rates, low inflation, and weak growth. As long as these important directional drivers of currencies continue to be low and stable we do not expect sustained directional moves in EURUSD. Instead, we should see a continuation of the tendency towards mean reversion of the past five to six years.

Seen in this light, the two currencies that are far away from their recent ranges are JPY and EM currencies (the latter of which still largely and irrationally trades as a group rather than individually). With respect to JPY, we expect that Japan will struggle to escape the clutches of its structural problems, despite enormous stimulus, which should favour a stronger JPY over the next few years. By contrast, EM currencies have upside at current levels, particularly if sentiment changes back in favour of EM rates.

Longer-term, we believe the outlook for EM currencies remains very strong, particularly for larger currencies. We expect Dollar weakness to play a major part in deleveraging the US economy as inflationary pressures gradually emerge over the next few years.

Expected performance of EM equities
EM stocks have underperformed US stock markets by more than 25% in 2013, resulting in the largest valuation gap since 2007. The relative underperformance reflects weaker earnings in EM over the past year and higher risk premiums due to macro, political and social uncertainties. In 2014, we expect earnings growth to recover as the global growth cycle picks up. This is particularly beneficial to large caps, which often derive a majority of revenues overseas. Many EM equities have been oversold as fundamentals continue to strengthen.

In conclusion
As valuations become too cheap to ignore, we expect investors to return in earnest to the asset class. China, Korea, Russia and Peru offer some of the most attractive opportunities, based on market multiples and growth outlook.

We maintain a cautious stance on ASEAN markets, mainly on macro and political risk; however, we are finding selective opportunities in specific stocks where the market has been oversold and fundamentals are strong and stable. We expect markets in India to recover as the political outlook fuels domestic sentiment.

We maintain an underweight position in South Africa on an unfavourable outlook in earnings and economic weakness. Mega-caps are particularly attractive across the board following the market correction in 2013, which has driven several stocks to historic lows. As the cycle recovers, we expect these companies to revert to long-term average.

Within small caps, we also maintain an overweight position as we expect these companies to do particularly well due to a recovery in domestic demand and sales to suppliers of larger global companies responding to a pickup in foreign order flow. We are finding consumer and industrial stocks attractive, as well as a few technology companies enjoying accelerating demand for mobile internet services.

Within Frontier Markets, we remain bullish after a strong 2013. Middle Eastern stocks have surprised significantly on the upside, despite the constant spate of negative news stemming from the civil war in Syria and unrest in Egypt. The relative outperformance of these markets indicates the degree to which they can be insulated from domestic issues in neighbouring countries. The announcement by MSCI to upgrade the UAE and Qatar to EM status in June 2014 provided a big boost to equity markets there; however, Saudi Arabia, which is not in any major index, also delivered strong positive returns.

Africa continues to remain a destination for investors seeking long-term, uncorrelated growth opportunities. Nigeria is set to overtake South Africa as the continent’s largest economy, other markets such as Ghana and Botswana are shining on improved governance standards, and liquidity is improving as foreign investor flows grow. Last year alone, trading volumes tripled in frontier markets against strong fundamental results.

We expect these positive trends to continue in 2014.

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