Turning point for lagging emerging stock returns?
Over the past year emerging markets have broadly lagged an upswing in global equity markets, yielding cumulative returns of 4.5 percent since last August. That’s less than half the return developed markets have provided (see graphic below).
But there are two reasons why a turning point may be approaching. First the positioning. Foreign holdings of emerging equities have plunged in the past six months and according to research by HSBC they are at the lowest in four years. That’s especially the case in Asia, where fund managers have been jittery about China’s growth slowdown.
International funds appear to have responded aggressively to signs of a slowdown in emerging market economies, the bank observes, adding:
This could be a positive signal for emerging equities if economic conditions subside…particularly for Asian markets where holdings are lowest.
Valuations are the other attraction. Emerging equities are trading around 10 times forward earnings —a fifth below developed market peers. In China, which comprises about 18 percent of the main MSCI emerging equity index, valuations are near record lows. EM valuations have been “sustainably lower” only back in 2002 or during the depths of the 2008 crisis, notes James Bristow, who runs a global equity portfolio at U.S. asset manager Blackrock in London.
Hard times for EM in QE-less world of higher US yields
Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what’s next for emerging markets? Most observers put this year’s stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That’s kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.
Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that’s an environement in which EM assets tend to underperform.
For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve, pushing the spread between 2-year/10-year Treasuries almost 100 bps wider. Flows to emerging markets dipped sharply, the following graph shows:
Money did continue to flow into emerging local bonds and equities in this period, albeit at a slower pace. But from local bonds the return was negative, HSBC notes. That could be an indication of what’s to come:
The carry trade is not dead yet but the change in tone by the Fed suggests it may have passed its best days.
Headwinds for emerging markets may in fact be greater now than 18 months ago. U.S. growth expectations haven’t budged much HSBC says: the bank expects U.S. growth under 2 percent this year and in 2013. On the other hand emerging market output gaps are much tighter than they were 18 months back and oil prices are higher. That makes the outlook for emerging local currency bonds more challenging, especially as a stronger dollar will give EM currencies less room to rise.
Should ongoing improvements in U.S. data result in further hawkish moves from the Fed and if such changes see U.S. yields rise further, we would expect this to be positive for the dollar vs EM . The combination of a potentially more inflationary backbone and a more challenging backdrop for EM FX might become a headwind for local rates.
Slipping up on oil and Greece?
Thursday’s crude oil price surge to its highest in almost 4 years (apparently due to a subsequently denied report from Iran of a Saudi pipeline explosion…phew!) illustrates just how anxious and dangerous the energy market has become for world markets yet again this year and HSBC on Friday spotlighted its threat to the global economy and asset prices in a note entitled “Oil is the new Greece”. The point of the neat headline hook was a simple one:
With Greece disappearing, at least temporarily, from the headlines, investors have quickly found a new source of anxiety thanks to the recent surge in oil prices
Just like many investors and strategists over the past month, HSBC rounded up its various assessments of the impact and fallout from higher oil prices, stressing the biggest risk comes from supply disruptions related to the Iran nuclear standoff and that any major political upheaval in the region would threaten significant crude spikes. “Think $150 or even $200 a barrel,” it said. It reckoned the impact on world growth, and hence the broader risk horizon depended on the extent of this supply disruption and the durability and scale of the price rise. Worried equity investors should consider hedging their portfolios by overweighting the energy sector. Obvious winners in currency world would be the Norwegian crown, Malaysian ringitt, Brazil’s real and Russia’s rouble, the bank’s strategists said. The most vulernable units are India’s rupee, Mexican and Philippines pesos and Turkey’s lira.
Earlier this week, strategists at JPMorgan Asset Management said crude oil exposure could be useful to them as a hedge to their relatively neutral positioning on world equities.
We also added exposure to crude oil, as a partial hedge in portfolios. We believe this provides some offset to a neutral stock/bond position, should the global business cycle prove to be stronger than expected. To some extent, it also acts as a “tail hedge” against geopolitical event risk, given the febrile situation in the Middle East.
But the question of whether oil packs as much a threat for world markets as the systemic risks posed by the Greek debt collapse is an interesting one. Certainly the sort of random, nervy price movements late Thursday are reminiscent of the edgier days of the now two-year-old euro crisis. Familiar too is the often unfathomable second-guessing of political developments in the euro zone. Yet for many people oil is just the new, well… oil.
It’s not really gone away over the past 18 months as an all-pervasive menace to the world economy and concerns about peak oil and the long-term decline in global supplies means even the slightest distortion to either supply or demand in future will likely instantly bring it back to the dashboard of all global investors. The 60% surge in crude prices between August 2010 and April 2011 was arguably just as powerful in sapping world economic activity in the second half of last year as the euro crisis was — perhaps moreso. And even as financial markets and economics commentariat talked openly in the final months of 2011 of a western banking and sovereign debt collapse leading to a double-dip recession and even a worldwide depression — crude oil prices never had a weekly close back below $100 for the remainder of the year!
End of LTRO = end of equity rally 2012?
This year’s global equity rally is unlikely to survive the end of the ECB’s liquidity injections, warns HSBC.
World stocks have jumped 10 percent since the start of 2012, emerging markets are up 15 percent and the index of top European stocks has gained 8 percent. These gains, HSBC says, are almost entirely down to the European Central Bank’s end-December refinancing operation, or LTRO, that injected $500 billion to ease banks’ liquidity worries. The tentative improvement in the U.S. and global growth picture along with beaten-down stock valuations added only limited ammunition to the rally, the bank says.
The findings of HSBC’s analysis? First, past episodes of quantitative easing — Japan in 2001-2004 and the United States, Britain and the euro zone after 2008 – provided a significant fillip to equity markets. U.S. stocks rose an average 6 percent, UK stocks by 8 percent and euro zone markets by 15 percent in the three months following the post-Lehman QE rounds, though in Japan the gains have been short-lived. Second, unexpected changes in monetary policy produced a larger impact on stock prices than the continuation of a previous policy.
And when QE stopped, the effect on stocks was immediately negative. HSBC found:
The periods when the Fed halted QE and allowed its balance sheet to shrink (in August 2009, June to October 2010 and July to October 2011) were all periods of weakness for the stock market.
The ECB is gearing up for another LTRO round in two weeks time. But it will not come as a surprise to markets and there are no plans for more.
HSBC concludes:
Clinging to hope in bear-bitten Russia
Poor Russia. After spending six months as the world’s best performing emerging market, the Moscow bourse has been the big loser of this month’s rout – year-to-date returns of over 10 percent until mid-July have since dissolved in a sea of red, with a plunge of over 20 percent since the start of August. As oil prices fell and the outlook for U.S. and European growth darkened, overweight positions in Russia halved versus July, a survey by Bank of America/Merrill Lynch showed this week.
But get this — Russia remains among investors’ main emerging market punts and only Indonesia is more favoured, according to the BoA/ML poll. The reason is that fund managers are still clinging to hopes that an increasingly wealthy Russian consumer will save the day. Unfortunately those hopes are yet to materialise. Returns on domestic demand-based stocks such as Sberbank, carmaker Avtovaz and supermarket chain Magnit have been even more disappointing this year than the broader Moscow market.
Even the staunchest Russia bull will have been disappointed with data showing Russia’s economy grew at just 3.4 percent in the second quarter of the year. That proves the economy was running out of steam even before the August oil price fall and suggests that the Russian consumer is not yet stepping up to the mark. Retail data since then have been more heartening — annual sales rose 5.6 percent in July from 3 percent in June.
So which way could Russia go? Some like Russian investment house Aton say another 20-25 percent stock market drop cannot be ruled out if the global economy goes into a tailspin. That sounds overly pessimistic – - as UBS analysts point out the global macro backdrop and the oil price outlook do not look nearly as bad as 2008. Chinese growth too is holding up well.
Three things are in Russia’s favour. One is that prices for oil, the mainstay of the Russian economy, remain over $100 a barrel – that should allow the government to keep spending ahead of elections. Second, most other emerging markets look uglier. Stocks in fellow-BRIC India may have fared better during the August selloff but the picture is far from rosy. Growth is slowing, as testified by factory expansion that fell for the third straight month in July and car sales that are down for the first time in over two years. The central bank remains uber-hawkish. Little surprise then that the BoA survey showed India to be investors’ least favoured market.
The clincher could be valuations. Russian stocks, always cheap, are even cheaper after the selloff, trading at just 5 times forward earnings — almost half the emerging markets average. For that reason, John Lomax, HSBC‘s chief emerging equity strategist reckons the current market dip is a buying opportunity. The market will recover if fears of a U.S. double-dip recession prove unfounded, he says.
In 10/20 years time, you will have in Russia one of the leading markets in the world along with the asian tigers, brazil and india. Not much left to say that shall be the post-crisis rulers.
Which BRIC? Russia scores late goal for 2010
How quickly times change. Russia’s stock market, unloved for months, last week overtook India to be the best-performing of the four BRICs. The Moscow stock index jumped 5 percent last week, posting its biggest weekly rise in seven months, bringing year-to-date gains to 17.5 percent. Fund managers such as Goldman Sach’s Jim O’Neill, creator of the BRICs term, are predicting it will lead the group next year too.
So what’s with the sudden burst of enthusiasm for Moscow? One catalyst is of course soccer body FIFA’s decision to award the 2018 Soccer World cup to Russia. Investors are piling into infrastructure stocks, with steel producers especially tipped to benefit as Russia starts building stadia, roads and hotels. But the bigger factor, according to John Lomax, HSBC‘s head of emerging equity strategy, is the optimism that has started creeping in about U.S. — and world economic growth.
Some of that may have been dampened by Friday’s lacklustre U.S. jobs data. But overall, checks of U.S. economic vital signs show the economy looking sturdier than it was six months ago and most banks, including the pessimists at Goldman Sachs, have upped 2011 growth forecasts for the world’s biggest economy. And China and India are continuing to grow at rates close to 10 percent. All that is great news for the commodity and oil stocks — the mainstay of the Russian market. Merrill Lynch, for instance, expects oil prices to be $10 higher by next December than now.
“Investors are getting more confident about the cyclical upturn,” Lomax says, citing oil prices and the recent rise in U.S. yields. “So you want to be in Russia which is a global growth play.”
The icing on the cake is the price of Russian stocks. They trade around 6 times 2012 earnings compared to 10 times for emerging stocks as a whole. Goldman’s O’Neill points out fellow-commodity exporting BRIC, Brazil, trades at much higher valuations while the currency too is more expensive. And India, this year’s runner-up is likely to suffer from a double whammy of high inflation and extremely high valuations — Mumbai trades at 16-17 times 2012 earnings.
PIGS, CIVETS and other creature economies…
Given the ubiquity of BRICs and PIGS, it seems everyone else in the financial and business world is attempting to conjure up catchy acronyms to group economies with similar traits. All with varying degrees of success.
HSBC chief Michael Geogehan has been championing ‘CIVETS‘ to describe Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa as the next tier of developing economies poised for spectacular growth.
Evoking the skunk-like animal blamed for the spread of the deadly SARS outbreak in Asia is not exactly auspicious but then it will probably be less offensive than the porcine moniker for Portugal, Italy, Greece and Spain. The collective term — with permutations such as PIIGGS to include Ireland and Great Britain among the list of debt-ridden countries — has been denounced by politicians in Portugal and Spain.
In less troubled times, of course, these economies were often dubbed ‘Club Med’, with all its associations of sun-saturated holidays by the sea.
No such allusive qualities exist in PriceWaterhouseCoopers‘ ‘E-7′. The consultancy’s term for fast-growing emerging economies China, India, Brazil, Russia, Mexico, Indonesia and Turkey could well be the name of a face-cream or some other chemical compound.
Also carrying a hint of the pharmaceutical is ‘N-11‘ — the handy shorthand for Goldman Sach‘s ‘Next 11′ group of countries that could take their place as the world’s largest economies alongside the original BRIC giants Brazil, Russia, India and China this century.
Goldman, of course, is behind that most widely used acronym for the ‘Big Four’ of emerging economies. Others have jumped onto the bandwagon, tagging other developing economies to the original four to come up with ‘BRICK’ (‘K’ for South Korea) and the hard-to-pronounce ‘BRIMC’ (‘M’ for Mexico). Less intuitive permutations include ‘BRICA’, which includes Arab economies such as Saudi Arabia and the United Arab Emirates, and ‘BRICET’, which includes Eastern Europe and Turkey.
Why Egypt or Saudi Arabia? Mexico, Indonesia, South Korea and even the UAE I understand but not Egypt and Saudi Arabia.
Shock! Emerging capital controls may just be working
Do capital controls work? After years of telling us that they do not, the IMF and World Bank reluctantly conceded last year they may not be all that bad and indeed in some cases they may actually help keep away some of the speculators who have in recent years been pouring into emerging markets.
Developing countries for the most part like foreign capital, indeed they rely on it for development. What they don’t like is hot money — short-term speculative flows which are widely blamed for causing past emerging market crises. So starting from October last year several of them slapped controls on some of this cash. There are signs these may be working.
Take the experience of two large emerging markets, Brazil and Indonesia. Brazil shocked foreign investors last October with a 2 percent tax on all flows to stocks and bonds. Nine months on, investors are still putting their cash there and Brazil has raked in millions of dollars thanks to the tax. But many fund managers, like HSBC’s Jose Cuervo, who runs a $6 billion portfolio of Brazilian stocks, are buying American Depositary Receipts (ADRS) of Brazilian firms rather than stocks listed in Sao Paulo. Because ADRs are in dollars and listed in New York, investors are getting exposure to Brazil but sidestepping the tax. Brazilian firms continue to receive investment but Brazil’s currency is not appreciating like it was last year. A win-win all around.
Indonesia’s measures, introduced in June, are relatively mild in comparison — as part of its aim to push speculators out of short bonds and into less volatile longer-dated debt, it now requires foreigners to hold these bonds for a minimum 28 days. That is bad news for hot-money investors who like to move in and out of a market quickly. The result — by mid-July there had been a 37 percent surge in foreign ownership of longer debt and yields on the short bonds rose as foreigners pulled out. So most foreign fund managers haven’t been scared off at all — foreign holdings of Indonesian bonds recently hit record highs.
Indeed emerging markets have been lacklustre this year. Not really due to the capital controls but because people are worried about state of the U.S. and euro zone economies and prefer to keep their cash closer to home. But the Institute for International Finance says the fear of more capital controls is one reason investment flows to emerging economies are likely to be lower this year than originally forecast.
Fund managers acknowlege there is a psychological impact to capital controls. The success of Brazil’s step has bred fear that it may increase the size of the levy especially if its real currency starts rising again, says Brett Diment who oversees $5 billion in emerging bonds at Aberdeen Asset Management. “So from that point of view (the tax) has been a successful measure in that it is limiting currency appreciation,” he says.
What do the multi-lateral lenders say? A paper by IMF economists a few months back acknowleged “an effect on the composition of inflows rather than the aggregate volume” resulting from such curbs — just the result the emerging economies are looking for.
Bosch Boss Bashes Bloated Bank Bonuses
Everyone complains about fat banker bonuses, but Bosch Chief Executive Franz Fehrenbach is taking the debate to a new level. The head of the world’s biggest car parts maker is going to review ties with its financiers and may break off business with those that pay excessive bonuses, he told reporters. “We find it irresponsible if some big banks more or less go back to business as usual before the crisis despite what we have gone through,” he said. He cited HSBC and JP Morgan as positive examples of good corporate behaviour. Of course it’s easier to be picky when you are unlisted and generate huge cash flow.
