EM STOCKS: Holding pattern

It’s been a rollercoaster year for emerging market securities. Things started with a bang: in the first quarter of the year, according to data from the Bank for International Settlements, cross-border lending into emerging markets increased by $267 billion to more than $3.4 trillion.

Stocks from Shanghai to São Paulo were on a multi-year tear, as yield-hungry global funds fled record low interest rates in the US and Europe, and systematically rotated holdings from bonds into equities, a process more pronounced in developed world markets. Then came Fed chairman Ben Bernanke’s May 22 taper speech, appearing to herald the beginning of the end of quantitative easing (QE).

Suddenly, emerging market stocks were as popular as chickenpox. By end-August, according to data provider EPFR, net year-to-date inflows into emerging markets had turned negative; outflows totalled $11 billion. Hardest hit were India and Turkey, major oil importers with high structural deficits. In June alone, $20 billion was stripped out of emerging equity funds, beating the previous record of $18.7 billion, set in January 2008.

Listing activity slowed. Emerging corporates issued just $32 billion-worth of initial public offerings (IPOs) in the current year to September 15, according to figures from data provider Dealogic, down from $76 billion in the same period two years ago. “The appetite for emerging market assets just disappeared for a while,” notes Benoit Anne, head of global emerging market strategy at Société Générale. “This created some seriously challenging conditions for anyone seeking to raise capital on the equity markets.”

Suddenly, all eyes were on the West. Eurozone nations lined up to issue good (or in some cases, marginally less awful) economic news, as did the United States. In early September, US Treasury yields rose above 3% for the first time in more than five years. A few eager analysts predicted a period of lingering stagnation for emerging markets.

Others weren’t so sure, and for good reason. Having fled emerging market stocks in June and July, investors crept back in August in search of buying opportunities. A few clarion voices suggested emerging equities, far from being a bad bet, were now oversold. Richard Titherington, chief investment officer for emerging market equities at JP Morgan Asset Management, predicted in early July that stock prices would first rebound, then consolidate their revival. His view was contrarian but correct. Between June 24 and September 17, the MSCI Emerging Markets index gained 13.4%, beating the S&P 500, which gained 7.9% over the same period.

India’s Sensex, which dipped below 18,000 in mid-August, recouped all its post-May 22 losses within a month. Leading bourses in Brazil, China and Russia all largely regained ground lost over the summer, while by mid-September the JSE in Johannesburg was closing in on record highs.

And there was a final twist in a crazy, chaotic summer for emerging equities: on September 18, bookending his May speech, Bernanke shocked financial markets by opting to maintain the Fed’s quantitative easing policy, at least for a while.

END OF EASY MONEY

The great taper will happen sooner rather than later: analysts at Deutsche Bank say the first move will likely take place in December. That points, Capital Economics adds, to no movement on US interest rates “until 2015 at the earliest”.

The decision, while ultra-cautious, was logical, given the Federal Open Market Committee’s (FOMC) evaluation of the fragile state of America’s housing market. The FOMC also downgraded its 2013 US economic forecast to 2.2% in 2013, against a previous June estimate of 2.5%, and to 3% in 2014 against a previous estimate of 3.3%.

Developing world equities should benefit in the short term from the Fed’s caginess. Neil Shearing, chief emerging markets economist at London-based Capital Economics, tips the “currencies and equity markets of the emerging markets that had been hit over the summer to rally the most”, pointing to strong rebounds in Indonesia, Turkey and India.

Yet as the year winds down, and with the taper put on hold, the question for many investors is how much hidden value resides in emerging market securities.

Most emerging market governments reacted decisively, if often marginally, to the summer slump, rolling out a series of mini-reforms. China in July and August quietly injected a new round of stimulus cash into its slowing economy; Brazil and Indonesia moved to support their currencies; South Africa took steps to stave off further social unrest in the mining sector; incoming Reserve Bank of India governor Raghuram Rajan announced a raft of sparkly new measures, including a swap window to draw in foreign currency dollar funds held by non-residents. Investors applauded, then rewarded.

Experts point out that this is a very different environment from that in the late 1990s, when emerging markets in Asia and Latin America reacted with passivity to the first signs of danger. To some, the September rally was just rewarding gruelling macroeconomic institutional reforms. Most large developing nations now boast lower external debt ratios, higher foreign exchange reserves, and more capable central banks than they did a decade ago. In an

August 30 note titled Don’t lose faith, Commerzbank’s emerging markets analyst Simon Quijano-Evans noted thatemerging market banks were “better equipped than many of their developed market peers to deal with shocks”.

FUTURE UNCERTAINTY

Many analysts believe a far bigger future issue is how key emerging markets react to a new and uncertain world. The Fed’s September meeting may not have proved as significant, at least for developing world stocks, as some had hoped. To be sure, the lack, at least in the short term, of a choreographed tapering process provided a short-term jolt for emerging equities. Bourses across Asia and Africa rose sharply in response to the Fed’s decision. India’s Sensex jumped 3% the morning after the meeting to its highest level in 33 months.

But others expect the medium-term impact to be limited. “Tapering was never the big issue many expected it to be,” says Capital Economics’ Shearing. Besides, far from being cut down in their prime, emerging equities had, notes David Aserkoff, CEEMEA equity strategist at JP Morgan, “been underperforming developed world equities all year”. All the Fed’s May 22 speech did, it seems, was to give investors a logical reason to flee an asset class that was already fighting for air.

Emerging markets, from frontier African states to the largest and most powerful of the Brics’ (Brazil, Russia, India, China, South Africa) grouping of nations, now face a different type of test. Most of these countries flourished in the post-Lehman world, as capital sought out growth and yield. Yet very few opted to take really tough decisions during the good times: liberalizing certain sectors of their economies, supporting private enterprise at the expense of state interests, slashing bureaucracy and corruption, boosting institutional capacity. Emerging market central banks may be better equipped to stave off currency crises, but at a corporate level, governance remains woeful, some critics say.

The challenge ahead, indeed, is doubly daunting. Assuming the West’s fitful economic recovery continues – and given the Fed’s tepid prognosis, this cannot be taken for granted – emerging markets will need to push through politically contentious reforms, while actively dressing to impress global funds.

Neither task will prove easy. Global funds, now casting covetous eyes at the shapely dividends and (in the longer term) higher Treasury yields on offer in the West, may be happy to revert to what they know. “Would you really go into riskier emerging markets if you had the chance to buy US or European equities?” asks John-Paul Smith, global emerging markets equity strategist at Deutsche Bank in London. “I would suspect the answer is ‘no’.”

PICKIER INVESTORS

An August research note co-authored by HSBC’s global head of emerging market research Pablo Goldberg highlighted the scale of the task ahead. Capital flowed into emerging equities post-Lehman largely, Goldberg wrote, because of the relative “ugliness” of developed markets rather than any genuine “prettiness” on display among Shanghai, Johannesburg or Mumbai stocks. The systematic removal of an ultra-accommodative US interest rate policy, he added, “suggests [continued] weak flows into emerging markets if growth does not re-accelerate.”

Thus we face a future in which global investors will likely become pickier, viewing emerging markets in clusters, rather than as a single, amorphous asset class. Funds should flow to countries willing and able to push through painful reforms: dismantling state monopolies and oligopolies, boosting corporate governance, and allowing the private sector to flourish.

Mexico has proven adept at maintaining growth while initiating and consolidating reform, though it remains an outlier in the emerging world. Governance, notes JP Morgan’s Aserkoff, is “stagnating” across the board. Deutsche Bank’s Smith adds: “You have countries where the state actively intervenes to the detriment of minority shareholders, and that’s getting worse.”

Brazil, where private enterprise is being throttled to death, is one of the worst offenders. More than one major emerging market investor interviewed for this story described the Latin American giant as their least-favourite emerging market pick. India remains stifled by bureaucracy, a paralyzed government, looming elections, and an oftentimes hostile attitude to foreign business.

Then there’s China, where Premier Li Keqiang talks about the need for greater economic diversification: more consumption, less state-led investment. Yet contrast words with actions, notably Beijing’s recent mini-stimulus plan, which handed a capital boost to export-geared state firms. “This is absolutely the wrong type of growth,” warns Shearing. “China talks up diversification, but what they really mean is more stimulus.”

The past five years have been good to emerging markets. Global funds, fleeing the low-growth West, pounced on stocks from Shanghai to Mumbai to São Paulo. But growth and yields are rising in the West, while the taper, despite the Fed’s September surprise, still beckons. Can emerging markets react to the new challenge by pushing through tough, necessary reforms? Only time will tell.