From star performers to troubled markets

For a long time, investors made a simple calculation: Emerging markets grow faster than developed countries, and consequently, in the long run, it is worthwhile to invest there. Between the fourth quarter of 2002 and the fourth quarter of 2007, this strategy worked extremely well. The MSCI Emerging Markets Index easily increased fivefold during this time. Since then, however, the picture has changed.   

Currently, the benchmark index for the emerging markets, which includes 838 shares of 23 emerging countries, trades at a low level not seen since August 2006. In the past four years the stock markets of developed countries outperformed those in emerging markets on a regular basis.  

In 2015 the markets were again lagging far behind, but the relative development is secondary. Recent losses in the MSCI Emerging Markets Index broke a long-term sideways trend and constituted a technical sell signal. 

 

Many disappointments  

Given the explosive chart situation, the big question is what has changed compared to the bull market between 2002 and 2007?  

With an estimated 2015 GDP growth rate of around 4 percent, the emerging economies on average are still growing faster than the developed countries, where an increase of just 1.9 percent is expected. However, the pace of economic growth has roughly halved since 2007, and perhaps even more importantly, the growth advantage compared to the developed countries has shrunk. 

Another explanation for the lost momentum in the stock markets of emerging countries is that corporate profits struggled to meet analysts’ expectations. In recent quarters, the results lagged the forecasts and a turnaround is not in sight.  

To create more momentum, it would be important to implement market economy oriented reforms. Some countries push for these reforms, and especially for India the hopes are high in this respect. But it remains to be seen what eventually can effectively be implemented.  

Recently some developing countries once again made negative headlines. With Ukraine, Russia, Argentina, Venezuela, Brazil, Nigeria and North Korea, the list would already be long enough to remind investors of the still higher risks in the emerging markets. As if that were not enough, Greece adds another problem child to that list.  

 

Western companies with emerging markets focus also suffer  

But all this fades in comparison with the problems of the world economy, should China falter more than it already does. The officially reported economic growth rate of around 7 percent is already a multiyear low, but the question is whether this figure is inflated. On the basis of the reported power consumption in China, economists at the French corporate and investment bank Natixis estimate a growth rate of only 2 percent.  

Since China served as the growth engine for the world economy for quite a while, serious problems in the Middle Kingdom leave traces in the rest of the world. This was recently demonstrated when the decision to devalue the yuan sent shock waves through the financial markets worldwide. 

Western companies that have orientated their business strategy more toward the emerging markets are also negatively affected by difficulties in China. A multinational consumer goods manufacturer like Colgate Palmolive, for example, generates around 50 percent of the sales in Asia, South America or Africa – a fact that investors rewarded for a long time with a valuation premium, since they assumed superior growth rates because of that emerging markets focus.  

But now that the gold rush has dissipated somewhat, these shares are no longer in such high demand. Not without reason, the shares of U.S. companies with a stronger focus on emerging markets have recently fallen to their lowest level in more than a decade compared to the broad U.S. stock market. 

Through the price pressure, commodity companies have to deal with an additional negative effect caused by lower economic dynamics in the emerging markets. With regard to the resulting consequences for the economies of emerging markets, there are winners and losers connected with the falling commodity prices.  

Commodity exporters like Russia, Indonesia, the Gulf States and some Latin American countries are considered to be the losers, while commodity importers such as China, India, Turkey and several Asian countries are counted as winners. In the short term, a lot depends on how the producer countries can cope with the changing environment. The bottom line is emerging economies as a whole could benefit from falling commodity prices in the long run, at least if the low commodity prices are not signaling a new recession. 

 

Valuation nearly in line with the 10-year average   

Another very important risk factor comes with a potential rate hike in the U.S. from the outside. An interest rate turnaround in the U.S. could be a problem if the yields of U.S. government bonds would rise and if that would cause a further withdrawal of capital from the emerging economies. The already weak currencies of these countries could stay under pressure and cause inflationary pressures via higher import prices.  

That would make an independent interest rate policy isolated from the U.S. even more difficult. In addition, such a scenario would be a problem because the debt in emerging economies has increased significantly in recent years at all levels. According to asset manager BlackRock, companies from the emerging markets added $371 billion in debt last year alone. This is almost four times more than in 2005. Much of this has happened in foreign currencies and when their value rises, financing this debt will become more costly. 

Hopes to get off lightly are nevertheless fueled by the long lead time everybody had to prepare themselves for the interest rate turnaround in the U.S. In addition, the valuations of emerging markets stocks are now significantly lower than they were at the end of the last bull market 2007.  

The price earnings ratio of the MSCI Emerging Markets Index stands currently at 11.8. That is only a little bit higher than the 10-year average of 10.3 and much lower than the price earnings ratio of 15.7 for the MSCI World Index. That is better than the valuation premium emerging markets temporarily were granted and takes into account the higher risks compared to the developed countries. 

Thus it makes sense to follow the advice of JPMorgan Chase. “It is not the time to play the hero in the emerging markets,” says the local emerging market Research Chief Luis Oganes. This is consistent with the new sell signal of the MSCI Emerging Markets Index.  

Only when this is reversed and a buy signal is generated, will the emerging markets have the possibility to change from troubled kids to star performers again. 

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