The sell-off in emerging markets should not obscure their attractions
ARE investors falling out of love with emerging markets? The stockmarkets of developing countries were one of the few bright spots in investors’ portfolios during the first decade of the 21st century. But since October 2010 they have steadily underperformed markets in the developed world (see chart).
That trend has continued in 2013. Emerging-market equities fell by 2.9% in May, leaving the MSCI EM index down by 4.4% since the start of the year compared with a 10% gain for the world as a whole. Other asset classes have been equally disappointing. Investors in emerging-market bonds have lost 4.8% so far this year, and JPMorgan Chase’s emerging-markets currency index fell by 3.3% in May, its biggest decline in a year.
The main attraction of emerging markets is their superior growth prospects, but economic data have been falling short of expectations. The average level for emerging-market purchasing-managers’ indices (in the manufacturing sector) in May dropped below 50, signalling contraction. There was a decline in 11 of the 14 emerging-market PMIs monitored by Royal Bank of Canada. A gauge created by Capital Economics, a consultancy, indicates that emerging markets grew by an annual rate of 4% in the first quarter, the slowest growth since the third quarter of 2009. Both the IMF and the OECD recently cut their 2013 growth forecast for China, the largest developing economy.
Weaker commodity prices (The Economist’sindex is down by 4.7% so far this year) are further evidence of the slowdown in emerging markets, since they have been the fastest-growing source of demand. This is also bad news for developing nations that produce commodities.
The danger is that companies in the developing world may have overinvested on the expectation that rapid growth would continue. Martial Godet of BNP Paribas points out that the return on equity for emerging-market firms has fallen from 17.7% in July 2008 to 13.2% today.
Meanwhile, sentiment in the rich world has recovered a bit. Data on the American economy, although mixed, are on balance better than they have been; even the euro zone managed to post better-than-expected manufacturing PMIs in May. There is much talk of a renaissance in American manufacturing, fuelled by the bonanza of cheap energy in the form of shale gas. “For the past 50 years, a vibrant US economy has meant strong external demand for EM economies,” says Manoj Pradhan of Morgan Stanley. “Should the US return to sustainable growth, it will likely return as a competitor for emerging markets and not as a consumer.”
The prospect of American recovery points to another issue: the hints from the Federal Reserve that it is mulling a slowing of quantitative easing. Even if the Fed does taper its asset purchases later this year, this will not represent the end of easy monetary policy. What the Fed taketh away, the Bank of Japan still giveth. But Simon Derrick of BNY Mellon thinks that there is a change in attitude towards the dollar, which had been on a weakening trend since 2002. If the Fed is the first big central bank to tighten monetary policy, the dollar is expected to rise, especially as emerging-market monetary policy is still being eased: 11 developing-world central banks have cut rates in the past two months. “The outflows from the dollar that have proved so supportive for emerging markets over the years appear to be drying up,” says Mr Derrick.
This combination of factors may be persuading investors to pull assets out of the developing world. According to EPFR Global, a research firm, in the last week of May global emerging-market equity funds suffered outflows of $1.4 billion, the biggest sell-off since late 2011.
The question is whether the recent underperformance is part of a longer-term cycle, like that in the late 1990s, or a shorter-lived development as in late 2008 and early 2009. Some of the current worries may be overdone. Just as investors often become overenthusiastic about emerging markets during booms, they can get too depressed in bear markets. Emerging markets still offer faster growth than the rich world. They have much better fiscal positions, too: government debt averages 33% of GDP.
The best rule of thumb is not to buy emerging markets when they are the consensus trade and when they look relatively expensive. At present emerging-market shares trade at a 25% discount to their developed-market peers. They have been cheaper in the past, but a further period of underperformance will make them very attractive to long-term investors.