Is now the time to invest in emerging markets?

No – Jeffrey Sacks

Emerging market (EM) equities have had a tough few years. Since early 2011, the MSCI Emerging Markets index has fallen by 30 per cent. By contrast, developed market (DM) equities – as represented by the MSCI World Index – have risen by 30 per cent. 

Among other things, EMs have suffered from the effects of a sharp slowdown in China as well as from softening global trade and a variety of political tensions. As a result, EMs as a whole now look lowly-valued compared to DMs. So is it time to switch our longstanding preference for DMs over EMs?

On a long-term view, EMs’ prospects may indeed now be brighter than those of DMs. That is certainly the message from Citi Private Bank’s own strategic asset allocation methodology. Its estimated return for EM equities is an annualized 10.4 per cent over the next decade. By contrast, its estimate for developed market equities is 6 per cent a year for the same period. However, these estimates do not necessarily tell us much about what will happen over the shorter tactical horizon of 12 to 18 months that our Global Investment Committee addresses. 

DM equities are less attractively valued than EM equities over this shorter-term horizon, trading on 19 times prospective earnings compared to 14 times for the latter.  However, we believe that DM could sustain these valuations for a while especially with the ongoing assistance from central banks’ monetary easing. DM earnings could benefit from the firmness of the US economy, which is one of the main engines of global growth.  DM equities also look attractively-valued compared to DM sovereign bonds, which is another source of support.

Despite our ongoing preference for DMs over EMs, we do see some selective tactical opportunities in EMs. One bright spot that we identify for certain EMs is the early-stage recovery in the oil price. Latin American equities had suffered as a result of the decline in crude oil since 2014 – and of commodities more generally over the past five years. However, its oil-exporting economies stand to experience some relief from oil’s rebound. Despite Latin American equities’ gains in 2016 so far, we believe their lowly valuations leave scope for further upside.

More broadly, though, EMs remain weighed down by sluggish global trade and ongoing weakness in general commodity prices. The structural slowdown in China’s economy has dented demand for many industrial commodities, such as copper. In some emerging countries like Turkey and South Africa, challenging domestic economic and political environments are compounding the problems caused by trade and commodity softness.

Within EM, the risks have shifted away from Latin America and towards Asia where China has unresolved structural weakness. We have therefore cut our overweight in Asian equities to neutral and reduced our underweight in Brazil equities. We stress that all of this is in context of our gradually reducing overweight to global equities, with DMs still overweight.   

Yes – Ajay Kapur

After five years of advocating a consistently bearish stance, we believe the time has come for investors to make a longer-term bullish commitment to both Asia ex-Japan and EM equities. While the anchoring effect of five years’ underperformance is a powerful downer, we believe we are now at an inflection point that is likely to challenge the winners of the past five years and boost the losers. 

Firstly, valuations are at attractive levels on both an absolute basis and relative to global indices. Meanwhile, the 33 per cent appreciation in the US dollar from mid-2011 to early 2016  is likely to expand the US dollar current account deficit, thereby generating US dollar liquidity. The natural corollary is more competitive Asian/EM currencies. About 40 per cent of the 23 EM markets we track saw their currencies fall to their most competitive quartile this year. These levels are likely to boost Ebit (earnings before interest and taxes) margins going forward.

We believe that historical capex for a global industry and for broad economic regions is also a useful leading indicator of prospective Ebit margins. One of the reasons we were bearish on Asia/EMs five years ago was that these markets had gone on a capex spending spree after the crises of 1997-2002. 

Now, however, we can see the capex binge in Asia reversing itself. The situation is similar in Latin America and more mixed in emerging Emea. Conversely, in both the US and Japan, the capex/GDP restraint of the global financial crisis has been reversed . So it is quite possible that over the coming few years, everything else being equal, EBIT margins in Asia and EM will begin to rise versus those of the US and Japan. 

What is more, just as the delayed impact of more competitive currencies and restrained capex in many markets may lead to better Ebits, the lagged impact of prior weakness in commodity prices should also translate into better terms of trade for Asia’s commodity importers.  

China’s monetary policy is also gaining traction, boosting property prices nationwide in a country where the property market accounts for 57 per cent of household wealth. Imposing negative real deposit rates on China’s savers to financially repress them makes sense given China’s 250 per cent (non-financial sector) debt-to-GDP ratio. This is the standard operating procedure to fight debt deflation – it is a bullish sign that policymakers have figured this out. 

Finally, we also see potential upside from state-owned enterprise (SOE) reforms. SOEs account for about 50 per cent of EM market capitalisation, and these companies have consistently underperformed since a peak in 2009. We think EMs as an asset class are going nowhere without SOE reform. 

Following the commodity price collapse, however, complacency in EMs has begun to crack. The US QE-driven flow of debt into EMs has peaked, and bond/equity flows are harder to come by. A renewed public backlash against corruption, more expensive and less available capital, and deteriorating fiscal positions are likely to drive an inflection point in EM SOE reform. 

There are, of course, risks to our view – namely a strengthening in the US dollar, tightening of Chinese monetary policy, a global recession or lack of SOE reform. But, overall, we think the time for elegant scepticism and bearishness is over – we have been there for five years now. The time has arrived to get out of the bunker, off the fence and start overweighting Asia/EMs.