Emerging markets wary of European fallout

The MSCI Emerging Markets index shed one fifth of its value during 2011 in the face of inflationary fears and the European sovereign debt turmoil. However, these markets are still growing at a healthy clip compared with their developed peers while the US, their major consumer, may be staging a recovery.

Inflationary pressure mounted as commodity prices fluctuated violently, especially oil, amid political upheaval in the Mena (Middle East and North Africa) region, and adverse weather conditions forced up food prices, which comprise up to 50 per cent of emerging market cost-of-living baskets. Developing nations, which are seen as high beta and are very sensitive to global risk appetite, were hit by the flight to safety as global markets faced multiple headwinds.

“It is well documented that emerging markets had a disappointing year, underperforming the developed world by about 10 per cent, and we think next year will be another challenging year for emerging markets, and for equities as a whole,” says Brian O’Reilly, head of wealth management research UK at UBS.

“The most serious risk is how much they are impacted by Europe, which after all is the world’s largest economic block,” he adds.

Although the European crisis remains the ‘elephant in the room’, Mr O’Reilly believes emerging market equities could return 5-10 per cent in the latter half of 2012, if a resolution can be found.

Many commentators have been surprised at the lack of political will among European leaders to ring-fence this crisis, however, and fear a repeat of 2008. Europe’s peripheral countries face funding costs at near record highs, despite a series of measures that have been hammered together to restore investor confidence in the eurozone. More than €457bn of eurozone government debt must be repaid in the first quarter of 2012, according to Citigroup. Italy alone for example has to repay around €113bn.

Chinese stockmarkets also fell heavily last year with Hong Kong’s Hang Seng index losing 20 per cent and the Shanghai Composite down 22 per cent, according to Bloomberg, yet few have lost faith in Asia’s long-term structural story. Drivers of growth such as the development of infrastructure, still huge in Brazil for example, the long-term development of consumer markets and an abundance of raw materials that increasingly industrialised countries want to access are not a one-year horizon stories.

A DIFFERENT WORLD

Confidence can also be taken from the behaviour of developing nation economies in 2008 compared with historical crises. “2008 was different from any other crisis because emerging markets fared well compared with other markets,” says Nordea Investment Funds’ head of global distribution, Christophe Girondel.

“It’s clear the world has changed when European officials are going to Asia to raise money. And these countries are good at favouring growth and adapting their interest rate policies, particularly the Chinese.”

Big changes in The Communist Party of China could herald a more expansive monetary policy as food price inflation begins to moderate.

“A housing collapse remains the key risk in the Middle Kingdom, but China has an ambitious social housing policy with plans to build 36m affordable homes by 2015,” says Mr O’Reilly at UBS. “In addition, unlike indebted nations in the West, China still has $3,000bn in reserve so they should be able to engineer a soft landing.”

A lot of negativity has been priced into Chinese equities squeezing valuations to 8.6 times forward earnings, even for companies generating a 70 per cent return on capital employed and dividend yields of 3 per cent.

Property developers are more exposed than the domestic householder in the housing market, and there are plenty of banks that are not overexposed to this sector, such as Russia’s Sberbank, which has a solid Tier 1 capital ratio and makes a 6 per cent net interest margin. Arguably, low valuations in the telecoms sector are also ample compensation for risks, and the data growth in handheld devices and laptops coupled with low fixed line coverage makes for a wonderful combination in developing regions.

Fund managers are particularly drawn to Chinese stocks in the small to mid cap sector that have been punished excessively.

“The government's pro-growth policies should make smaller and medium-sized companies, particularly the latter, deserving of renewed interest going into 2012,” says Agnes Deng, investment manager of Baring’s Hong Kong China Fund.

“Recently the People’s Bank of China cut the bank reserve requirement ratio by 50 basis points, the first reduction since December 2008. This could encourage banks to lend additional money and should provide strong support to economic growth.”

China’s dynamism may have been undersold. The International Monetary Fund estimates economic growth came in at 9 per cent in 2012, more than double the predicted global growth rate of 4 per cent.

“People expect a hard landing in China and GDP growth under 6 per cent but we believe there is ample room to stimulate the economy on both the monetary and fiscal side, and growth could be 8 per cent or slightly higher,” says Wim-Hein Pals, head of emerging markets equities at Robeco. “There could be no hard landing or indeed no landing whatsoever. ”

Mr Pals believes 2012 could prove similar to 2009 when emerging market outperformed mature markets, although not to the same extent.

India is also attractive on a valuation basis having fallen 23 per cent last year. The depreciation of the rupee (down 19 per cent against the US dollar in 2011) also leaves equity valuations at an attractive entry point for investors, particularly cyclical companies. The Indian market is now trading on 12.5 times forward earnings, 15 per cent below its historical average.

Again, inflation has been the overriding concern with India’s CPI staying consistently above 9 per cent for each of the last 12 months, but as energy and food price falls feed through, the Reserve Bank of India should be able to cut rates significantly. Avinash Vazirani, manager of the Jupiter India Fund, predicts inflation will fall by a further 250bps between January and the end of March 2012 to around 6.5 per cent.

“There is a fear that corporate profitability will be significantly affected by the fall in the rupee due to foreign currency borrowings by Indian companies and higher commodity prices, as they are dollar denominated,” says Mr Vazirani.

“Indian corporates were generally able to withstand the 10 per cent currency devaluation in the third quarter of 2011, but clearly certain infrastructure companies and others with dollar borrowings were affected.”

However, this is only a very small part of the Indian stockmarket, and, despite the negative currency impact, profits grew by roughly 10 per cent year on year in the third quarter, says Mr Vazirani.

“Companies with large dollar borrowings generally have significant overseas assets, and are generally hedged through foreign sales or receivables over a longer period,” he adds.

FALLING INFLATION

“Inflation will become less of an issue in 2012 as inflationary pressures moderate in response to slower economic growth and food inflation rolling off,” says Dhiren Shah, co-manager of BlackRock’s Global Emerging Markets portfolios.

“This should allow the authorities to cut interest rates and when monetary policy is accommodative, this has traditionally helped multiple expansion. Interest rates have been reduced already in China, Brazil and Russia and more nations will follow, and consequently in the second half, growth should re-accelerate. “

While lower inflation on the back of commodity price falls of 15-20 per cent will be welcome news for most developing nations, it will damage Russia’s economy at a time of heightened political political risk, as evidenced by the recent Duma elections and subsequent protests in Moscow.

South Korea also faces increased risk of conflict with the North as King Jong Il’s 29 year old son and successor, Kim Jong Un, is an unknown quantity.

Despite last year’s market falls, not all emerging market companies are cheap however. “Valuations in emerging markets exceeding 20 are not uncommon and that’s across various geographies such as Brazil, Mexico, China and Russia,” says Wojciech Stanislawski, fund manager, emerging markets, at Comgest.

“Many consumer related companies are at historically high price levels so it has become more difficult to find value in consumer stocks,” he explains. “Valuations are attractive in industrial stocks, telecoms and utilities although the earnings of some of these companies are a bit uncertain in the short-term.”

Mr Stanislawski still has 30 per cent exposed to consumer stocks, which is still high compared with the index, but lower than his previous 50-60 per cent weighting. He has been progressively buying into “solid companies where investors sold off very quickly everything that is not perfect”.

At Fidelity, Alex Homan, product director in the emerging markets team, is focusing on stocks with sustainable revenues servicing domestic consumers in Asia and Africa, and is staying away from more economically sensitive materials, particularly iron and steel, where supply dynamics threaten the outlook for raw materials pricing.

He says it is possible to maintain a defensive stance by buying into precious metal stocks where rises in precious metal prices have driven dollar-based revenues, while cost bases in depreciating local currencies like the South African rand have both had a very positive effect on these companies’ cashflow profiles.

Looking ahead, the broad challenge for the asset class will be the introduction of new reforms to allow economic development to move forward, such as labour market regulations, tax reform in Brazil and potential liberalisation of the energy market in China and the power sector in India.

Fall in stock valuations creates opportunities

Emerging market stocks are a volatile universe but the volatility works in both directions, and over time investors should enjoy outperformance on the way back up.

Leo Grohowski, chief investment officer at BNY Mellon Wealth Management, believes the 2011 slide of emerging market equities is an enormous opportunity for investors because these markets were penalised more than their underlying fundamentals justified. However, he says that clients require persuasion to stay in these markets, and are certainly not willingly increasing their exposure to them.

Mr Grohowski explains that in 2008 a typical allocation to developing nations amongst BNY Mellon’s clients was around 3 per cent, but by 2009 it had risen to around 9 per cent, and this remains a good target, with actively managed funds the current preferred route.

There are several good fund manager franchises in this space but they are well recognised and a number have been subject to capacity constraints. However the fund outflows of last year are helping to ease that problem.

For example, emerging market mutual funds in the US enjoyed inflows of $64bn (E50bn) in 2009 and $84bn in 2010, but $34bn fled in 2011. These markets are also much deeper than even a few years ago, and now account for 12.5 per cent of global stock capitalisation.

“ETFs (exchange traded funds)are useful for generating quick and focused exposure, but we like to think we are moving back into the type of market environment that will reward the work asset managers do on research,” says Simon Miles, head of Merrill Lynch Portfolio Management in Europe, Middle East and Africa.

“There is a broad spread of active emerging market managers and there have been some disappointing performances, but we have also seen some good performances, particularly from defensive managers who have been producing a better return over time,” he explains.