Is the bubble set to burst?

The tremendous rise in emerging market equities since late 2008 divides investors between those who fear a bubble, and those who believe there is more growth to come. Groups such as Vanguard and First State have expressed nervousness at the sheer weight of money that has chased emerging markets up. Others, including Citigroup, Schroders, Pioneer and Aberdeen, have come out saying they expect more growth from these markets and continued inflows for the next 12 to 15 months.

In the short-term, the quantitative easing and loose monetary policy pursued in the West should continue to drive money flows into potential growth zones, but looking ahead many developing countries are now developing their own problems, such as rising inflation. Chinese inflation is running at 5.1 per cent – its highest rate for more than two years – prompting central bank governor Zhou Xiaochuan to turn his attention to interest rates, hiking them for the second time in three months on Christmas Day.

Other emerging countries, particularly across Latin America, are suffering from overvalued currencies which are damaging their export businesses. For example, Brazil’s President Dilma Rousseff is planning tough tax and tariff measures to counter the real’s 100 percent rise since 2003. Competitive devaluation could be a problem as countries throughout the region attempt to depress their currencies’ value and take other measures to boost local production and exports.

Increased risks

“Despite the positive outlook for emerging markets next year, risks have increased,” says Nicolas de Skowronski, head of investment advisory, at Bank Julius Baer. “Inflation pressures are rising across the asset class, pointing to overheating risks, and incidence of protectionism, mainly on the part of developed economies, is also rising which in turn could damage global trade. Thirdly, emerging markets that are well advanced in the economic cycle, such as Brazil, are good candidates to carry out fiscal tightening.”

Staying with a pro-cyclical fiscal position could prompt overheating, and the recent rise in core inflation readings underscore the importance of adjusting policy, warns Mr de Skowronski. “However, although emerging market valuations have increased as of late, they still remain sufficiently below their peaks – investors seem happy paying for the higher growth and robust fundamentals that emerging markets and we don’t disagree on this front,” he says.

There are indications that valuations in emerging markets are tipping into bubble territory, however. The local subsidiaries of big western companies such as Walmart and Unilever are trading on multiples of several times more than their parents in the developed world.

“Our view is that the bubble is not here yet, but if you strip out all the big state-owned enterprises across India, Brazil, and China which are on smaller multiples because they are cyclical and often have small free floats, then you are left with stocks with multiples of around 25 times, which is arguably too high,” says Hugh Adlington, investment director at Rathbones.

“Many general emerging market funds have risen by 20 per cent compound over 10 years so one could argue that shares have priced in a lot of the positive growth story.”

On asset-based measures, such as price-to-book value, emerging markets are beginning to look expensive compared with their Western counterparts.

“At the moment the rate is 2.4 price-to-book value which is above the long term average of 1.9-2.0 price-to-book,” says Andy Brown, an investment manager on the global emerging markets equities team at Aberdeen Asset Management.

“This means markets are not cheap but they have on previous occasions risen to 2.6-2.7 times book value at the height of cycles, so that gives us some feeling that the markets could yet go a bit higher.”

Low correlation

One misconception is that rising GDP growth equates to a rising stock market. Vanguard has examined the data for 1900-2009 and looked at the correlation of 16 major markets, some of which were emerging at the time.

“Our analysis shows that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero,” says Jeff Molitor, Vanguard CIO for Europe. “This holds across the major equity markets over the past 100 years, as well as across emerging and developed markets over several decades.”

“For example, two countries that had similar growth per capita were Italy and Sweden which across the whole period grew on average by 2.1 per cent per year and 2.3 per cent per year respectively but Italy’s stock market grew by 3 per cent per year on average while Sweden’s grew by 8 per cent on average. Belgium experienced an average GDP per capita growth of 1.6 per cent per year but its stock market grew by an average of 2.2 per cent per year, while Australia has less GDP growth than Belgium, but enjoyed an average annual equity return of 8 per cent,” says Mr Molitor.

“Intuitively, emerging markets should trade at a relative discount. Over the course of the 2000s, this discount disappeared due primarily to a compression in the valuations of UK (and other developed markets) stocks but also due to a persistent increase in valuations for emerging markets through late 2009,” he explains.

“Today, relative valuations between UK and emerging markets are at relative parity, suggesting that the case for continued outperformance of emerging market stocks may not be as concrete as either past returns or projections for economic growth would suggest.”

Strong fundamentals

For the bulls, however, the central thesis is that many companies in emerging economies are making good profits, and have strong fundamentals, healthy cash flow profiles and attractive dividend yields.

Wim-Hein Pals, head of emerging markets equities at Robeco, argues that forward PEs – which are about 12 – are still cheap. “Some investors are becoming nervous because the asset class has done so well for so long,” he explains.

“I’d argue that it is not the old cyclical asset class it was 10 years ago – the growth is much more structural, and the dynamics are much more intra-regional and not (so much) dependent on the US anymore. And any growth from the US next year will be an additional boost in exports.”

Some of the fund inflows are a genuine rebalancing of international portfolios on the part of long-term investors, and this could continue for years, but there is also evidence of a tactical shift to performance-chasing. In particular, pension funds and other investors are switching out of local fixed interest products such as low yielding domestic bonds, as negative sentiment about bonds grows.

The so-called “New Tiger” economies are the newest recipients of these strong inflows. Initially seen as Hong Kong, Singapore, South Korea and Taiwan, the Tigers have expanded to include South Africa, Argentina, Indonesia and Turkey – countries with very high growth rates that are likely to become industrialised in the near term, and which also rely less on exports. Korea in particular is seen as the perfect combination of healthy domestic recovery and strong links to the Chinese consumer.

Flight to safety

There is a similar shift from cyclicals and export companies to defensive sectors such as healthcare and consumer staples, typically supermarkets Massmart in South Africa or Bim in Turkey.

Cyclical industries, such as mining, account for some 35 per cent of the MSCI EM index, making it vulnerable to any downturn in demand from developed countries. The ability of emerging market exposure to diversify a portfolio is also hampered by the domination of each emerging market by a handful of domestic stocks.

In Brazil, for example, the top five stocks account for 48 per cent of the Bovespa market’s total value, and even in India, the least concentrated, that figure is 23 per cent.

“Investors should be aware of the drivers behind each of the asset classes and markets,” says Mr Adlington at Rathbones.

“They might choose instead western listed companies or types of funds that are highly correlated to Chinese or emerging market equity markets. For example, the mining sector is a big chunk of the UK FTSE 100 and that is closely correlated with emerging markets because it is driven by emerging market demand. It’s the same with any commodity exposure.”

Andy Brown, Aberdeen Asset Management