The first two months were very promising for emerging market inflows. Spurred by the European Central Bank’s (ECB) introduction of the first long term refinancing operation (LTRO), investors turned risk on and flooded into emerging market equities, pushing the MSCI Emerging Markets index up to 15% by March – well on course to hit the 20% end-year gain expected by some analysts, earlier in the year. But the upward trend was short lived. March saw a downturn in the market, and strong year-to-date gains in the index disappeared by the end of the month. While investors fear a Greek exit from the eurozone and as China’s economy continues to slow down, investors are distinctly risk off. Although not an emerging market crisis, emerging markets, classically measured, tend to underperform in a risk-off environment.
“Emerging markets will be hit the hardest by a Greek exit: Capital flows will continue to leave and currencies will fall as investors become even more risk off,” says an emerging market equity analyst at a leading investment bank in London. As David Marshall, senior analyst at CreditSights says, decoupling is a myth: “As some wits have pointed out, when markets are falling the only thing that goes up is correlation,” he says.
And emerging Europe will be hit the most because of close trading ties with the rest of Europe and fragile economic fundamentals. “Hungary, for example, has the worst structural fiscal deficit of all emerging markets,” explains a London-based analyst. “Government debt is around 80% of GDP which is very high when you consider that next in line is India with only 60% debt to GDP ratio."
Asia will prove the be the most defensive region in terms of its beta score against the Greek and European banks’ indices, led by the Philippines, Malaysia, Thailand, Taiwan, China and India, according to analysts.
The recent underperformance of emerging market equities has also been driven by a cooling of interest from index-trackers, which are new to the asset class. “Previously, long only money consisted of 60% of full flows in emerging markets, and ETF was 40%... this reversed and ETFs – looking to get more emerging market exposure because of poor fundamentals and growth in developed markets – accounts for 60% of all flows," says the London based analyst. He added: "But uncertainty in Europe and negative investor sentiment has encouraged an exodus of ETF from emerging markets. This is why we are seeing emerging market equities performing badly. If the [MSCI EM index] falls it will be very worrying. If the trend continues, long only money investors might begin to pull out too.”
“Equities have underperformed globally but this has varied region by region," says Stephen Mo, emerging market equity strategist at UBS in London. "The best performing region this year is the US market, whereas European markets have capitulated. Emerging markets are somewhere in-between those two. Events in Greece will determine whether emerging market equities recover or not in the short term.”
But some analysts are bullish, arguing that robust action by policymakers to stem the rot will trigger yet-more liquidity in the global financial system, depressing yields on conventional fixed income assets, a boon for emerging market stocks. Citi, for example, predicts a Greek exit at some point this summer, which will inevitably put asset classes under pressure in the short term, but regional and international action is also anticipated. “The big question at Citi is at what point will the ECB, and other central banks, come in with a fiscal package to protect the system and cushion the fallout? I think a package will most likely be implemented after the withdrawal of Greece from the Euro,” says Geoffrey Dennis, Citi''s global emerging markets strategist in New York. "Similar to the affect LTROs had at the beginning of the year, a relief package will pump liquidity into the system and markets will fly."
Dragon in the room
The clout that China has on all emerging markets should not be underestimated either. “Everyone puts the major sell-off of emerging market equity in May to feelings over Greece. But many forget that in April, Chinese economic data was poor and this too damaged investor sentiment and encouraged a sell-off. A hard landing in China is an important influence on emerging market equity as well,” says Dennis.
But if China can ease its economic troubles, emerging markets will be more resilient to Grexit. On Monday, Chinese premier Wen Jiabao announced that there would be additional easing and will provide more support for the Chinese economy. “Although we admit we have been waiting for this for a long time, we predict that the Chinese economy will finally begin to improve in the second half of this year,” says Dennis, a well-known emerging market bull.
“We still hold a bullish view on emerging markets and we are not surprised that there was a pull back. What we are surprised about, however, is that scale and speed at which the pull back occurred,” admits Dennis. “But emerging markets are fundamentally in better shape than their developed counterparts, and at Citi, we think that the global economy is getting better.” And for those willing to take the chance, the steep drop in valuation could be the best time to enter otherwise pricier markets, says Dennis.
Mo agrees, but sees benefits in the longer term: “Longer term emerging markets are attractive. Valuations are cheap and are at a 30% discount relative to its own history. Once risk appetite recovers, emerging market equities will become attractive again. In general, emerging markets fundamentals are sound and supportive of strong economic growth, which in turn drives revenue and earnings growth. Buying them at these levels has typically been fruitful over a two to three year horizon.”
If emerging market equities outperform - thanks to the yields on offer and cheap liquidity - in the context of a global maelstrom post-Grexit, the development would be truly historic.
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Source: Citi