Global Investing

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

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:

Russian stocks: big overweight

Emerging stocks are not much in favour these days — Bank of America/Merrill Lynch’s survey of global fund managers finds that in August just a net 18 percent of investors were overweight emerging markets, among the lowest since 2001. Within the sector though, there are some outright winners and quite a few losers. Russian stocks are back in favour, the survey found, with a whopping 92 percent of fund managers overweight. Allocations to Russia doubled from last month (possibly at the expense of South African where underweight positions are now at 100 percent, making it the most unloved market of all) See below for graphic:

BofA points out its analyst Michael Harris recently turned bullish on Russian stocks advising clients to go for a “Big Overweight” on a market that he reckons is best positioned to benefit from the recovery in global growth.

Russia may not be anyone’s favourite market but in a world with plenty of cyclical headwinds, Russia looks a clear place for relative outperformance with upside risk if markets turn… we are overweight the entire market as we like domestic Russia, oil policy changes and beaten-up metals’ leverage to any global uplift.

September’s bond bonanza

What a half-month it has been for bond issuance! As we wrote here, many borrowers  — corporate and sovereign;  from emerging markets and developed  — have seen  this period as a last-chance saloon of sorts to raise money on global capital markets before the Fed starts to cut off the supply of free cash.

But the month so far has been different not only in the sheer volume of supply but also for the fact that issuance by governments of developing countries has surpassed emerging corporate bond sales. That’s something that hasn’t happened for a long time.

By the end of last week, sovereign issuance for September had hit $13.5 billion, more than any other month this year and a quarter of the total 2013 sovereign issuance so far, according to analysts at JPMorgan. In comparison, sovereign issuance historically averages $2.2 billion a month, rising to $5 billion every September following the summer lull.  Issuers were Russia with $7 billion, South Africa and Romania with $2 billion each; while South Korea and Indonesia raised $1 billion and $1.5 billion respectively. JPM writes:

Emerging markets: to buy or not to buy

To buy or not to buy — that’s the question facing emerging market investors.

The sector is undoubtedly cheap –  equity valuations are 30-50 percent cheaper than their 10-year average on a price-book basis; currencies have depreciated 15-20 percent in the space of 4 months and local bond yields have surged by an average 150 basis points. As we have pointed out before, cheapness is relative and the slowing economic and credit growth in many countries will undoubtedly manifest itself in falling EPS growth. Companies that cannot pass on high input costs caused by weak currencies, will have to take a further margin squeeze.

But many analysts have in recent days changed their recommendations on the sector. Barclays for instance notes:

With pension reform, Poland joins the sell-off. More to come

If the backdrop for global emerging markets (GEM) were not already challenging enough, there are, these days, some authorities that step in and try to make things even worse, writes Societe Generale strategist Benoit Anne. He speaks of course of Poland, where the government this week announced plans to transfer 121 billion zlotys ($36.99 billion) in bonds held by private pension funds to the state and subsequently cancel them. The move, aimed at cutting public debt by 8 percentage points,  led to a 5 percent crash yesterday on the Warsaw stock exchange, while 10-year bond yields have spiralled almost 50 basis points since the start of the week. So Poland, which had escaped the worst of the emerging markets sell-off so far, has now joined in.

But worse is probably to come. Liquidity on Polish stock and bond markets will certainly take a hit — the reform removes a fifth of  the outstanding government debt. That drop will decrease the weights of Polish bonds in popular global indices, in turn reducing demand for the debt from foreign investors benchmarked to those indices. Citi’s World Government Bond Index, for instance, has around $2 trillion benchmarked to it and contains only five emerging economies. That includes Poland whose weight of 0.55 percent assumes roughly $11 billion is invested it in by funds hugging the benchmark.

According to analysts at JPMorgan:

The most significant local market impact of the Polish pension reforms is likely to come from index-related selling as the weight of Polish government local currency debt in major global bond indices, including Citi’s WGBI and the Barclays Global Aggregate index, is likely to fall. Our base case scenario sees $3.5 billion worth of index-related selling, with risks skewed to the upside

US investors prop up emerging equity flows

U.S. mutual fund investors are ploughing on with bets on emerging market equities, according to the latest net flows numbers from our corporate cousins at fund research firm Lipper. Has no one told them there’s supposed to be a massive sell-off?

August was the 30th straight month the sector has seen net inflows, and the 9th straight month of net inflows above $1 billion. Sure, there’s a downward trend from the February peak, but the resilience of demand is notable given doom-laden headlines about how EM markets will fare once the Fed feels its generosity is no longer required.

Of course, the popular image of mutual fund investors is as a perennial lagging indicator for allocations trends, and the stage may be being set for a sharp turnaround this month. However, U.S. investors have already been offloading their bets on emerging debt, with funds in the sector seeing net outflows of $2.6 billion, or 7.5% of total assets, in the three months to end-August.

Signs of growth bets in the fund flows

Just as Germany helps to embolden hopes for a robust recovery in Europe, a look at detailed fund flows data offers more cheer to the optimists.

I’ve been seeing which equity fund sectors saw the greatest net inflows during July, and then filtering the top 20 by flows relative to the sector’s total assets. There’s a clear winner.

According to estimates from Lipper, funds and ETFs in the cyclical consumer goods and services category notched up net inflows of about $1.5 billion, the equivalent of 7.8% of overall assets under management and the largest monthly net inflow for at least ten years. Over the 3 months to end-July, net inflows were at close to $3.4 billion.

Tapping India’s diaspora to salvage rupee

What will save the Indian rupee? There’s an election next year so forget about the stuff that’s really needed — structural reforms to labour and tax laws, easing business regulations and scrapping inefficient subsidies. The quickest and most effective short-term option may be a dollar bond issued to the Indian diaspora overseas which could boost central bank coffers about $20 billion.

The option was mooted a month ago when the rupee’s slide started to get into panic territory but many Indian policymakers are not so keen on the idea

So what are the merits of a diaspora bond (or NRI bond as it’s known in India)?

Turkey’s central bank — a little more action please

In the selloff gripping emerging markets, one currency is conspicuous by its absence — the Turkish lira. But this will change unless the central bank adds significantly to its successful lira-defensive measures.

Hopefully at today’s policy meeting.

Like India or Indonesia which have borne the brunt of the recent rout, Turkey has a large current account deficit, equating to over 5 percent of its economic output. But what has made the difference for the lira is the contrast between the Turkish central bank’s decisive policy tightening moves and the ham-fisted tactics employed by India and Brazil.  (We wrote here about this).  See the following graphic (from Citi) that shows the central bank has effectively raised the effective cost of funding by 200 basis points to around 6.5 percent since its July 23 meeting.

 

Guillaume Salomon, a strategist at Societe Generale calls Turkey the “success story” given the relatively stable lira and expects the bank to raise the upper band of its interest rate corridor by another 50 basis points at least. He says:

Pakistan, Nigeria, Bulgaria… the cash keeps coming

The frontier markets juggernaut continues. Here’s a great graphic from Bank of America/Merrill Lynch showing the diverging fund flow dynamic into frontier and emerging equity markets.

What it shows, according to BofA/ML  is:

Frontier market funds with year-to-date inflows of $1.5 billion have decoupled from emerging markets ($2.1 billion outflows year-to-date)

In other words, frontier fund inflows since January equate to 44 percent of their assets under management (AUM), the bank says.