Wednesday, November 11th, 2015

Cherry Picking

It is some time since we wrote in detail about individual emerging markets, and there has been a noticeable uptick in the number of questions about them from clients. As far as the asset class is concerned we have to disappoint them; EM equities are still rated underweight relative to global equities. The underweight is not as extreme as it was in the summer, but there has been no real progress for the last month. The best we can say is that EM bonds have been upgraded to neutral vs global bonds and this is often a good indicator of what may happen to equities with a 2-3 month lag.

So what about individual countries? Here the picture is more encouraging. The four countries on our global positive watch-list are all from emerging markets: China, Taiwan, Chile and Russia. The kindest thing we can say about the Russian economy is that it faces a number of challenges, which are unlikely to be surmounted soon. However they are well understood and have been around for at least a year. Russia is not Greece; it has no problem with cutting social security and wages in the face of rapidly rising inflation. The devaluation of the rouble helps to protect the margins of the main commodity exporters, and the equity market is one the cheapest in the world. The trigger for our model is that volatility is down from stratospheric levels to something which is high but in touch with other emerging markets.

Taiwan and Chile are both China plays. For Chile the links are purely economic and heavily focussed on the copper price. For Taiwan there is also a direct connection between the two equity markets. Our view on China is a curious mixture of scepticism and faith. We are deeply sceptical about the quality of economic data, the sustainability of reported earnings, the health of the banking system and the trend of medium-term growth. We are equally firm in our belief that the Chinese authorities have a set of policy tools they can use to support the local equity index. These range from direct intervention to moral pressure to monetary easing. It’s not how the Fed would operate, but it looks as though it is succeeding. We made the call that it would work back in the summer and there has been no reason to change it since. Again we notice a material decline in volatility compared with the rest of the world since a peak in late September.

Switching from the winners to the losers, we note that commodity producers such as Brazil, South Africa, Peru and Indonesia are still unattractive. In a curious way this highlights the flexibility of the Russian labour market and the good governance of Chile.

There is one country which previously had many supporters which has suddenly started to struggle. India was one of our top three countries from May 2014 to February 2015. After that it fell into the second quartile, where it has remained until now. However our forward-looking indicator suggests that it is starting to come under pressure. This may be due to concerns that Modi’s reform programme is under threat, as evidenced by this week’s defeat for the governing party in state elections in Bihar. It may just reflect that India is now expensive on traditional valuation metrics. Whatever the narrative, the numbers are clear that India has lost momentum and investors will need a new set of reasons before they can be persuaded to buy it again.

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