Deutsche’s emerging markets bear sticking to his guns

April 30, 2013

Emerging markets bear John-Paul Smith first made his call to underweight emerging equities at the end of 2010. In a note released late on Monday he points out that such a position would have paid off handsomely — since end-2010 emerging equities have underperformed MSCI’s World index by 27.5 percent and U.S. MSCI by 37.6 percent.


Smith, who is head of emerging equity strategy at Deutsche Bank, sees no reason to change his call. Reckoning that the cyclical heyday of emerging markets is past, he is advising clients to hold on to developed and U.S. equities at the expense of emerging markets. The reason? China, pivotal for the rest of the EM world for commodities, trade.

Smith writes:

We are maintaining our existing underweight recommendations for GEM versus DM/US and current country weightings within GEM because the ongoing structural deterioration in the sustainable growth rate of the Chinese economy will continue to be the dominant narrative for the GEM equity asset class, in our view. Since the start of the year it has been increasingly evident at the micro level that the massive increase in total corporate financing has not as yet fed through into anything resembling a commensurate pickup in final demand.

Recent data from China would appear to bear that out. Economic growth and industrial data have both disappointed while Fitch has downgraded the country’s local currency rating, warning of risks to the economy from so-called shadow banking. And corporate results have not been reassuring — over 70 percent of companies, whether Hong Kong- or mainland-listed, undershot earnings forecasts for 2012,  according to Thomson Reuters Starmine data.

Smith again:

From a more bottom-up perspective, the ongoing deterioration in the underlying return on invested capital has now reached a point which threatens the viability of the entire economy.

So how China plays out will determine performance of the rest of the asset class. If China slows down gradually, emerging equities would underperform, led by commodity producers Russia and Brazil, while commodity importers such as India and  Turkey would gain. A more dramatic outcome in China would swiftly hit the most expensive markets such as Thailand and Malaysia, and also affect countries with current account deficits.

Within emerging markets, Smith is shunning Brazil, Russia, China and Korea but he has tactical overweights in Poland, Taiwan, Mexico, Turkey and is neutral/overweight in India — trades that would broadly benefit from a Chinese slowdown.

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