Wednesday, July 19th, 2017

No Case for Emerging Markets Yet

The problem for fans of Emerging Markets is that since the beginning of 2017, European equity markets have produced EM rates of return combined with DM levels of volatility and liquidity. The reasons for this are no great mystery. A robust recovery in the Eurozone, market-friendly election results, better progress on bank capital adequacy and a strong currency have all combined to boost returns.

For the first three factors cited above, there is no reason to think that they will go into reverse in the near future, but the currency could become a problem. Since January 2015, EURUSD has traded in a well-defined range of 1.05-1.15. One of the reasons why this year’s returns look so good in dollar terms is that they are inflated by over 9% as the single currency has gone from the bottom to the top of the range since January. However, from now on the situation gets more difficult; either the euro strengthens in which case European investors could start to take profits (as they did at the beginning of this week) or the currency stabilises/retraces in which case dollar returns will no longer benefit from this tailwind.

This could be the moment when investors start rotating into Emerging Market equities, but we have our doubts. None of the BRICS looks particularly attractive to us. South Africa and Brazil are mired in political scandals alleging corruption at the highest levels of government, and also have very disappointing growth rates. Russia’s fiscal deficit continues to widen and weak GDP growth is unlikely to improve unless the oil price rises to $60/bbl, which we also think is unlikely. For the last two months, these three countries have consistently been ranked in the bottom six out of over 40 global equity markets which we follow.

Neither India or China has a growth problem, but both have structural reform issues which could periodically affect the risk appetite of local investors. In India, two recent examples are the abolition of high denomination bank notes and the introduction of the nationwide goods and services tax. In China, regulators have yet to embark on a serious clean-up of bank balance sheets and some of the wealth management products offered to local investors are little more than Ponzi schemes. Ten years on from the start of the global financial crisis, we know it is possible to have a healthy economy and sick financial markets. The right reforms, properly communicated, and well-executed would lead to a rally in both countries, but for now they remain on or close to our negative watch-list.

This leaves us looking a second-tier emerging markets like Mexico, Korea, Turkey and Poland. Korea is large enough to make a difference to global portfolios, but not all index providers classify it as an emerging market, and it comes with a large geo-political risk called Kim Jong-Un. Mexico is well-understood by US investors, but the peso is always vulnerable to the US political cycle. Like the Eurozone, currency appreciation is a big part of this year’s excess returns. Turkey looks good now precisely because it looked so terrible a year ago, and can never be a core holding, while Poland is really a European, not an EM, story. If the three factors we cited at the beginning of this note remain supportive, we don’t see why investors would want to change a winning formula. The Eurozone and its near neighbours, apart from the UK, are producing better risk-adjusted returns than Emerging Markets.

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