Emerging equities: out of the doghouse

October 18, 2013

Emerging stocks, in the doghouse for months and months, haven’t done too badly of late. The main EM index,  has rallied more than 11 percent since its end-August troughs, outgunning the S&P 500’s 3 percent rise in this period. Bank of America/Merrill Lynch strategist Michael Hartnett reminds us of the extreme underweight positioning in emerging stocks last month, as revealed by his bank’s monthly investor survey.  Anyone putting on a long EM-short UK equities trade back then would have been in the money with returns of 540 basis points, he says.

Undoubtedly, the postponement of the Fed taper is the main reason for the rally.  Another big inducement is that valuations look very cheap (forward P/E is around 9.9 versus a 10-year average of 10.8) .

According to Mouhammed Choukeir, CIO , Kleinwort Benson:

Looking at valuations we think emerging markets are in an attractively valued zone, hence we think it’s a good investment. EMs are in negative momentum trend but have good valuations. We’re sitting on the positions we’ve built but if it hits a positive (momentum) trend we will add on it…. You wait for value and value will translate into returns over time.

But to sustain the current rally, a stronger catalyst will be required

The signs are good. Data today showed China’s economy accelerating for the second quarter in a row. More importantly, the outlook for developed economies is looking up and that’s something that has always benefited the developing world — in the shape of exports, investments and so on. And as PMI data has shown for a number of months, western and Japanese growth is on the uptick. PMIs in emerging markets themselves have been pretty dismal — average output growth for the third quarter was the lowest since early 2009, HSBC’s monthly survey showed — but according to UBS research that matters less. EM exports tend to follow developed market PMIs more closely than their own, UBS says.  (see their graphic below)

Here is another graphic from Julius Baer showing the sensitivity of emerging equities to the global cycle.

Julius Baer say it is time to build exposure to emerging markets; emerging earnings have a beta of 3.8 to global industrial production, second only to Japan’s beta, they note:

With global industrial production accelerating for the first time in three years, emerging companies are well positioned for an uptick in growth and stronger demand.

Richard Titherington, CIO for emerging equities at JPMorgan Asset Management says:

Yes, there is a brighter picture for the U.S. economy which EMs benefit from and there is also some degree of optimism over the outlook for China. While that’s only part of the EM story it’s the biggest part.  If you see the U.S. economy continuing to improve that will bring benefit everyone because the U.S. is still the single largest driver of consumption.

Here’s the rub, however. It is unclear if the correlation between U.S.  growth and emerging exports/equities will hold  in today’s world. Indicators in the United States, Europe and China have been looking up for some months now and financial conditions globally are very loose. Despite that there are only patchy signs of recovery in emerging markets exports.  Will this change?

Over to the UBS analysts:

Forward looking numbers in the U.S. have been reasonably strong  for some time now. Yet this has not resulted in an improvement in emerging market exports. We have made the case that this is because growth in the United States is coming through in sectors that don’t make much demand on goods that emerging markets produce (such as heavy machinery and transportation equipment for the shale gas industry)  So what’s new now? Well, quite simply, that U.S. growth has continued and hopefully this means that slowly the labour market improves and the recovery broadens out to other sectors in a manner that helps EM more.

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