Second quarter outlook for emerging markets stocks
The environment for equities in emerging markets is becoming more difficult but the developing world consumer remains a bright spot
A growing inflation problem in emerging markets is not getting better, on the contrary, "over time it is likely to become worse," but the developing market consumer sector benefits, rather than being hurt by inflation, according to John Lomax, head of global emerging markets equity strategy at HSBC.
Lomax says that the developed world, with sovereign debt and political constraints gradually being pushed to the side, is in the right side of the cycle to allow positive equity performance, while in the emerging world the output gap is generally much smaller and easy money in rich countries feed inflationary pressures, creating a "less constructive environment" for stocks.
Inflation matters because central banks might tighten policy to counteract it but also because if central banks respond insufficiently, labour and other costs will tend to rise, squeezing corporate margins, at least in the tradable sector.
"Non-tradable sectors, where there is more ability to raise prices in response to cost hikes, may show more margin strength," Lomax wrote in his strategy outlook for the second quarter.
As the consequences of the protracted financial crisis affect developed markets, the developed world "is gradually pricing itself back into global product markets, which overall seems likely to create significant challenges for many emerging markets corporates," he said.
"It could be argued that just as the developed world consumer rescued financially distressed EM after the Asian crisis, this is now happening in reverse. The EM consumer is playing an important role in rescuing a financially distressed developed world."
POSITIONING FOR CONSUMER GROWTH
The largest overweight equity position on any country for HSBC is Turkey, which "continues to benefit from the local and international cycles as well as a strong secular story."
In the local cycle, stocks tend to perform best when growth is subdued, inflation under control and the central bank is able to use its monetary policy aggressively to support domestic demand, which is the situation in Turkey, Lomax said.
He added that the country "also benefits strongly from the international low-growth, low-interest rate environment we currently inhabit."
In terms of market composition Turkey has the highest consumer-facing representation of any emerging market (with banks, consumer staples and consumer discretionary).
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The HSBC strategist has a small overweight on Brazil stock markets, which he believes faces "significant medium-term headwinds" because the economy has a weak potential growth rate and inflation will be a concern.
But economists at HSBC expect "a moderate upturn" in economic growth and an uplift in China's infrastructure cycle, which should help the outlook of Brazilian earnings.
The HSBC strategist is also overweight on Egypt, where a deal with the International Monetary Fund if it is concluded "has scope to provide an initial market catalyst."
"There is considerable pent-up demand both on the personal and corporate side, and this should progressively come through in the face of greater political clarity," Lomax said.
He is also overweight frontier markets, with 60.1% of stock markets being consumer-facing (weighting in banks, consumer discretionary and consumer stables) versus 43.6% in emerging markets.
His underweight positions include Hungary and Poland, which "have the highest correlations with Western European markets."
"We still see Poland as the most straightforward underweight," Lomax wrote. "The immediate macro environment remains difficult with weak growth and low interest rates set to continue to weigh, especially on banks."
Lomax is neutral on Russia, despite believing the Russian market is "clearly cheap." He says that Russia faces "severe challenges" structurally, both from the US and global shale gas revolution and from Chinese rebalancing.
The HSBC strategist is underweight South African equities as he believes that "both near term and long term this is one of the least exciting consumer stories in the EM space in terms of prospective growth."
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His underweight on Mexico "relies on high valuations and a near-term earnings disappointment."
In the Andean region, Lomax is overweight on Peru while he sees short-term headwinds in Colombia, especially downside risks for banks, and is underweight Chile.
In Asia, Lomax is overweight China due to low valuations and the possibility of some earnings upgrades later in the second half of this year, "assuming the economy continues its patchy recovery."
Chinese growth disappointed in the first quarter, coming in at 7.7% compared with market expectations of 8%. Lomax expects Beijing to keep fiscal and monetary policy accommodative in the coming quarters.
The HSBC strategist is overweight on Indonesia as well, saying that its growth model is resilient, backed by strong domestic demand and favourable monetary policy.
He is neutral on Thailand, Malaysia and South Korea and underweight Taiwan, India and the Philippines.
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