from Scott Barber:
Should emerging market equities trade at a premium?
Emerging markets have faster growth, lower debts and better demographics than developed countries, so you would perhaps expect their equity markets to trade on a premium. They don't.
Historically, investors have placed a higher multiple on developed markets - this may have been justified when developing countries seemed more likely to hit a crisis. Now that this has reversed shouldn't these countries be more highly valued? As the chart below shows, developed markets have consistently traded at a higher multiple than developed markets apart from a brief period in the mid-nineties. In late 2007 expectations of a decoupling brought the two market valuations closer together - the severity of the subsequent downturn hit emerging markets hard but since then they have traded on a lower P/E ratio. So far this year emerging markets are off to a strong start up over 10% but the valuation discount remains.
Could this just be due to a different sector breakdown? While some emerging countries do have lots of companies in some of the sectors that tend to be cheaper such as energy, financials or materials, at the aggregate level the weightings are fairly similar and a ‘sector adjusted’ P/E ratio shows the same overall pattern.
If we look within developed markets, those companies with emerging market exposure do seem to be rewarded with higher valuations - this would suggest investors believe in the better prospects of emerging markets but aren’t translating this to actual emerging stocks.
About-turn for Ukraine and Belarus debt
Emerging debt investors are a fickle bunch, even when it comes to neighbouring economies like those of the former Soviet Union.
They are starting to feast their eyes once more on Belarus, which less than a year ago looked close to default, while Ukraine, a favourite of 2010, is going out of fashion.
The export-oriented economy of Belarus has let its currency float as a condition of IMF funding, and money from the IMF and Russia has fended off payment difficulties.
Over in Ukraine, the central bank has not allowed its currency to weaken much and the country is having one of its regular spats with Russia over the price and volume of gas supplies. Ukraine is also in dispute with the IMF, and funds from the international lender have been suspended for nearly a year.
Maxim Raskosnov, analyst at VTB Capital, told emerging debt investors at an EMTA forum in London this week:
Twelve months ago, everyone was loving Ukraine and starting to dislike Belarus. This time around, Belarus has gone through 66 percent devaluation, and is now much more prepared to deal with economic challenges, whereas in Ukraine, nothing has been repaired. Ukrainian corporates comparable to Russian and Kazakh ones are suffering because they are located in Ukraine.
Ukraine’s five-year credit default swaps are quoted at around 835 basis points — okay, it’s lower than Greece or Portugal but twice as high as Italy — and the yield on its 2017 bond hit two-year highs this month.
Emerging markets facing current account pain
Emerging markets may yet pay dearly for the sins of their richer cousins. While recent financial crises have been rooted in the United States and euro zone, analysts at Credit Agricole are questioning whether a full-fledged emerging markets crisis could be on the horizon, the first since the series of crashes from Argentina to Turkey over a decade ago. The concern stems from the worsening balance of payments picture across the developing world and the need to plug big funding shortfalls.
The above chart from Credit Agricole shows that as recently as 2006, the 34 big emerging economies ran a cumulative current account surplus of 5.2 percent of GDP. By end-2011 that had dwindled to 1.7 percent of GDP. More worrying yet is the position of “deficit” economies. The current account gap here has widened to 4 percent of GDP, more than double 2006 levels and the biggest since the 1980s. The difficulties are unlikely to disappear this year, Credit Agricole says, predicting India, Turkey, Morocco, Tunisia, Vietnam, Poland and Romania to run current account deficits of over 4 percent this year.
Some fiscally profligate countries such as India may have mainly themselves to blame for their plight. But in general, emerging nations after the Lehman crisis were forced to embark on massive spending to buck up domestic consumption and offset the collapse of Western export markets. For this reason, many were unable to raise interest rates or did so too late. As the woes of the Turkish lira and Indian rupee showed last year, the yawning funding gap leaves many countries horribly exposed to the vagaries of global risk appetite.
There are some supportive factors however. The Fed’s signal this week that U.S. interest rates are unlikely to rise before 2014 shows that central banks in Europe and the United States will continue to gush money for now. So there should be enough cash available to plug the gaps in emerging nations’ balance sheets. Second, as growth eases, so will the deficits. For these reasons, Credit Agricole says the market will be forgiving of large current account deficits this year. But it warned:
What will happen once (developed market) rates are raised is another story, and emerging markets would better have fixed their main imbalances when the global monetary normalisation begins.
Central banking… what’s the future?
The Federal Reserve has taken a historic step of adopting an explicit inflation target of 2 percent at its two-day meeting ended on Wednesday, highlighting how central banks must adapt to the new post-crisis world.
In a new book “The Future of Central Banking”, Claudio Borio, deputy head of monetary and economic department and director of research and statistics at the Bank for International Settlements, argues that the financial turmoil has shaken the foundations of the deceptively comfortable central banking world.
”Pre-crisis, the quintessential task of central banks was seen as quite straightforward: keep inflation within a tight range through control of a short-term interest rate and everything else will take care of itself. Post-crisis, many certainties have gone. Price stability has proven no guarantee against major financial and macroeconomic instability,” write Borio, who is also a director of research and statistics at the BIS.
Borio proposes a set of three new guidelines for central banking in the future.
- Adjust current policy frameworks: Beyond letting central banks play a leading role in establishing fully fledged macroprudential frameworks, authorities must adopt monetary policy strategies that allow them to tighten to prevent the build-up of financial imbalances even if near-term inflation remains subdued. “Operationally, this calls for extending the policy horizons beyond the roughly two-year ones typical of inflation targeting regimes.”
- Reconsider monetary policy responses to the busts: Monetary policy should pull out all the stops to prevent the implosion of the system as the crisis erupts. But, thereafter, the priority should be to repair balance sheets and facilitate the necessary adjustments in the real economy.
- Strengthen operational independence of central banks: In crisis prevention, the autonomy of those in charge of macroprudential decisions is critical. “The political economy pressures not to take away the punchbowl when the party gets going are well known in the context of inflation, but they are even stronger when financial booms are underway.”
New year, new investment: CIC makes a head start
China’s sovereign wealth fund’s move last week to invest in London water supplier Thames Water puts focus on potential overseas investment in the year of Dragon from China’s central bank PBOC, which plans to create a $300 billion vehicle to invest in Europe and the United States.
After Reuters reported on the plan in December, the PBOC and State Administration of Foreign Exchange (SAFE), which manages reserves, have been mum. A tiny drop in the country’s reserves, still standing at $3.18 trillion, brings only a small comfort to the world’s largest reserve holder as it struggles with low returns on its sovereign debt portfolios in U.S. Treasuries (earning almost nothing) and euro zone sovereign debt (under growing risk of further ratings downgrades).
China, which regularly intervenes in the FX market to keep a lid on the yuan exchange rate to keep its exports competitive, is suffering ”negative carry” — the difference between the cost of intervention and its overseas investment.
This is how the negative carry arises: The People’s Bank of China buys U.S. dollars in the FX market. When it intervenes, it pumps yuan into the domestic banking system. This extra liquidity, if left, can cause inflation. The PBOC therefore needs to mop this up by issuing “sterilisation bonds”.
The sterilisation is not cheap. As foreign reserves keep accumulating, the PBC has to issue more debt for sterilisation purposes, which may drive up the interest rates on the PBOC bills.
So far, Chenying Zhang of the Wharton School at the University of Pennsylvania, argues that the PBOC’s income from foreign reserves investment has exceeded its sterilization cost consistently from 2003 to 2010.
Zhang, in her paper, estimated the PBOC’s cost of sterilization and compared it with its income from the foreign reserves investment from the period 2003 to2010. She finds that China’s FX reserves have to drop around 36% (or to put it in another way, the RMB has to appreciate by more than 50% against the US dollar) before it fails to cover the sterilization cost of the PBOC.
EM growth is passport out of West’s mess but has a price, says “Mr BRIC”
Anyone worried about Greece and the potential impact of the euro debt crisis on the world economy should have a chat with Jim O’Neill. O’Neill, the head of Goldman Sachs Asset Management ten years ago coined the BRIC acronym to describe the four biggest emerging economies and perhaps understandably, he is not too perturbed by the outcome of the Greek crisis. Speaking at a recent conference, the man who is often called Mr BRIC, pointed out that China’s economy is growing by $1 trillion a year and that means it is adding the equivalent of a Greece every 4 months. And what if the market turns its guns on Italy, a far larger economy than Greece? Italy’s economy was surpassed in size last year by Brazil, another of the BRICs, O’Neill counters, adding:
”How Italy plays out will be important but people should not exaggerate its global importance. In the next 12 months the four BRICs will create the equivalent of another Italy.”
Emerging economies are cooling now after years of turbo-charged growth. But according to O’Neill, even then they are growing enough to allow the global economy to expand at 4-4.5 percent, a faster clip than much of the past 30 years. Trade data for last year will soon show that Germany for the first time exported more goods to the four BRICs than to neighbouring France, he said.
“Post-crisis, these countries will be our passport out of this mess.”
But there has to be a payoff for this kind of increased financial clout, he warns. Developing countries are increasingly disgruntled about the the richer world’s strangehold on global policies via the International Monetary Fund and the World Bank and most have responded coolly to the call for additional funds for the IMF which is fighting to stem the euro zone malaise. An attempt last year to install a representative of the developing world at the helm of the IMF for the first time ever fell apart, with Europe retaining the position. But emerging countries could make a bid for the World Bank chief’s position this year, a position traditionally held by a U.S. citizen. O’Neill said the West had to bow to the new reality:
”You can’t have it both ways…This game of ‘You have the IMF and I have the World Bank’ has to stop or these institutions are going to lose their relevance.”
He is also dismissive of fears China is headed for a so-called hard landing, a sharp slowdown of growth, potentially leading to unemployment, a property crash and social unrest in the world’s No. 2 economy. ”A lot of people (in the West) want China to have a hard landing, ” he said. “And that’s because it isnt us.”
Iran looms larger on Gulf radar screens
Tensions over Iran may be helping to push up oil prices as traders worry about a widespread embargo on the country’s crude oil but markets in neighbouring Gulf energy-rich economies are not benefiting.
One year after the Arab Spring started in Tunisia, investors remain sensitive to political risk in the Middle East.
Debt insurance costs have risen sharply this month for gas exporter Qatar and oil giant Saudi Arabia, just as global worries appear to be easing about the euro zone crisis.
In Qatar, five-year credit default swaps have jumped 30 basis points in the past 10 days to 150 bps, according to Markit — their highest since July 2009. Saudi CDS have had a similar upward trajectory, while CDS in Israel have reached two-month highs.
Traders say some of this move is just a switching of earlier positions, as Gulf markets performed relatively well at the back end of last year, due to their perceived insulation from euro zone worries.
But as Chavan Bhogaita, head of the markets strategy unit at National Bank of Abu Dhabi, notes:
It has nothing to do with the fundamentals or the credit quality of these sovereigns, but simply about investors getting nervous due to the Iran situation. By buying protection through sovereign CDS, investors are trying to protect themselves against any possible sell-off in the event of an escalation in geopolitical tensions.
Iraq risks rise with violence
As political unrest once more seems to be a feature of the new year, with Nigeria and Romania among countries to experience protests, and the death toll continuing to rise in Syria, an increase in violence in Iraq is unnerving investors.
U.S. troops left Iraq at the end of last month, and on Dec 22 there were more than 10 coordinated bombings, followed by several further attacks this year.
Iraq’s tiny stock market was one of the best-performing in the world last year, gaining 30 percent where many emerging markets lost a similar amount. But prices have slipped nearly 5 percent this month.
The yield on the country’s $2.7 billion bond due 2028, issued in 2006 in a restructuring of commercial creditors’ debt, hit its highest in over two years last week.
Religare Capital Markets says in its 2012 regional geopolitical outlook that:
The outlook for Iraq is bleak…we maintain our view that the Iraqi government will fall apart this year and sectarian violence will escalate.
Consultancy Arabia Monitor also says in its Q1 review that while Iraq has a strong future as an energy post-war reconstruction play:
Home is where the heartache is…
On a recent trip home to Singapore, I was startled to learn just how much housing prices in the city-state have risen in my absence.
A cousin said he had recently paid over S$600,000 — about US$465,000 — for a yet-to-be-built 99-year-lease flat. Such numbers are hardly out of place in any major metropolis but this was for a state-subsidised three-bedroom apartment.
Soaring housing prices have fueled popular discontent — little wonder as median monthly household incomes have stagnated at around S$5,000.
For its part, the government — which houses 80 percent of people on the densely populated island — insists that public housing prices are shaped by ‘market forces’, pointing to a raft of financing schemes to help first-time buyers.
What’s less contentious is that Singapore is only part of a regional real estate boom that has driven property values by as much as 70 percent since the start of 2009 in cities such as Sydney, Hong Kong and Beijing.
Like Singapore, the government in China is acting to cool house prices that have skyrocketed in recent years out of the reach of a large swathe of its middle classes.
Chief among Beijing’s policy arsenal is social housing. The government is stepping up construction of public housing, targeting a rollout 36 million affordable homes from now until 2015. At the same time, clampdown on property speculation has also helped ease Chinese housing prices.
New year, new debt default?
This time last year it was Ivory Coast, and today it was Kazakh sovereign wealth fund-controlled BTA bank which failed to pay $160 million in coupons on its debt.
In late 2009, Ukrainian state energy firm Naftogaz restructured its debt, the same year government-owned Dubai World declared a standstill on coupon payments.
While we’ve all been looking at possible sovereign default in the euro zone, it’s easy to forget that other governments or state-linked entities may also be facing difficulties. In many cases, apparent state backing may not mean much if governments do not rush to the aid of cash-strapped firms.
Only today, Spain denied reports it was guaranteeing the debt of regional authority Valencia.
For BTA, which has said it wants to restructure its debt, this isn’t the first time
The bank restructured its debt once already in 2010 after defaulting in 2009, installing wealth fund Samruk-Kazyna as its 81.5 percent shareholder. It has since struggled with persistent bad loans, slow economic growth putside the commodity sector and the cost of servicing its government funding package.
The bank still has 10 working days’ grace period before officially defaulting on the payments. It is meeting shareholders to discuss the restructuring on Jan 26.
