Thursday, January 9th, 2014

Emerging Markets – Not Yet

New Year is a time for predictions, and this season has witnessed the usual crop of forecasts predicting that 2014 is the year when EM equities will outperform the US and / or the majority of the developed equity markets. We have to be careful about 12-month forecasts because a full calendar year is beyond the six-month horizon we claim for Harlyn’s models in normal circumstances. With that caveat let us review the history of recommendations for emerging markets vs the US and Europe in 2013 and discuss our current view.

Our US dollar model started 2013 with a clear preference for EM over US equities, but the peak had already passed and by mid-February it was suggesting that the probability of emerging markets producing superior risk-adjusted returns was below 50%. The main reason for the change was the strong performance of US equities at the start of the year, but comparisons with US Treasuries were also headed the same way – just with a two month time-lag. By the end of April, it was clear that the problem was not just relative but absolute returns.

Against European assets, the story was even bleaker because of the strength of the euro and sterling. Against Eurozone equities, the weight of EM equities has not been above 50% since August 2012, and for most of 2013 it was (and still is) well below 20%. In general all our models showed a plunging allocation to EM equities (and EM bonds) at least two months before the Indian rupee crisis began to accelerate in June.

Since then there has been no sign that EM equities are set for a convincing rebound against any of the main DM equity indices, despite the fact that they are already cheap (in the sense that relative PE ratios are below the long run average). We think that there are at least three reasons for this. (1) All commodity-related markets (e.g South Africa, Brazil, and Russia) will likely have to cope with another year of declining commodity prices (including oil). Supply and demand conditions vary by market, but the over-riding problem is tighter monetary policy in the US. (2) A recovery in the US will probably lead to more capital repatriation on the part of US investors, putting further pressure on local exchange rates and the balance of payments. (3) The resulting boost to competitiveness will be offset by the energy cost advantage enjoyed by US manufacturing thanks to the shale oil revolution. Exports to the US will grow, but not by as much as they did at this stage of the previous cycle.

Eventually EM equities will recover (or DM equities will run into trouble: tighter monetary policy in the US and super-strong currency in the Eurozone), but our models suggest that the probability of this happening in the next six months is very low. This may start to change in the second half of the year, but investors do not need to invest now.

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