A boost for cheap emerging equities. So will they bite?

September 19, 2013

Emerging stocks have rallied 3 percent today after the Fed’s startling decision to leave its $85 billion-a month money-printing in place, and some markets such as Turkey are up more than 7 percent. With the first Fed hike now expected to come in 2015 and tapering starting only from December, emerging markets have effectively received a three month breather. So will the buyers return?

A lot of folks have been banging the drum about how cheap emerging markets are these days. But imminent Fed tapering has been scaring away any who might have been tempted. Plus there is the economic growth slowdown that could knock profit margins at emerging market companies. Bank of America/Merrill Lynch which runs a closely watched monthly survey of fund managers shows just in the following graphic how unloved the sector is relative to history:

So should people be buying? BofA/ML certainly thinks so: its strategist Ajay Kapur suggests emerging stocks are 20 percent undervalued. He acknowledges all the risks out there but reckons they are all in the price by now:

In sum, we think emerging equity markets are likely to surprise the negative consensus and do rather well in the coming months. Valuations discount a lot of the financial vulnerability, investors appear to have fallen out of favor with the asset class, China/global economic data are improving, and Asia’s terms of trade are getting better. While longer-term issues about over-investment, lending  booms and deteriorating current accounts remain a concern, especially in an environment of rising U.S. bond yields, a rising dollar, a falling U.S. current account deficit and rising oil prices, we think these are well discounted and understood.

Here is the other side though  — many reckon Fed tapering concerns were only a marginal factor behind emerging equity weakness. Rather, there are more structural reasons to justify the cheap prices, says John-Paul Smith at Deutsche:

Cheap valuations are insufficient to compensate for the multiplicity of governance concerns at both a sovereign and corporate level, which are likely to continue to drive down relative return-on-equity.

Emerging equities have been gradually de-rating since end-2010, Smith points out, even though Fed money-printing was in full swing all this time.  Come December, things may start to get a bit more clear.

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