Emerging market economies may have superior long-term fundamentals compared to those in the West, but they won’t escape the impact of the current Eurozone problems, says Willem Sels (pictured), UK Head of Investment Strategy, HSBC Private Bank…
Emerging market economies have superior long-term fundamentals when compared to those in the West, but we believe they will still be negatively impacted in the short term by the Eurozone recession. EM asset performance meanwhile remains vulnerable as long as global risk appetite is weak. We therefore remain selective for now, focusing on EM hard currency debt, which is often seen as the relative safe haven within EM assets. We prefer exposure to Asian assets over those in Latin America, and avoid Central and Eastern Europe due to their sensitivity to Eurozone woes. We also believe that countries with large domestic markets such as China, Indonesia and Brazil may weather global volatility better than trade-focused
economies.
Following a difficult year in 2011, emerging market (EM) assets have started 2012 on a more hopeful note, especially for equity markets. However, many risks remain and we maintain a relatively cautious outlook. In 2012, a number of factors are likely to impact emerging market performance and affect different asset classes. While the growth and monetary picture diverges significantly from that in the developed markets, we believe that EM asset performance will remain hostage to western developments.
1. Western slowdown to impact emerging market economies
In our view, the emerging markets are unlikely to be immune to a slowdown in developed market growth, even though EM policymakers have more tools available to support their economies. Indeed, while trade links to the West have slowed in recent years and EM countries have started to trade more with each other, they have not decoupled from the West and they remain dependent on the developed market growth outlook. Further, exports to the West remain significant, even if countries have started to focus on more domestic-oriented growth measures to try to reduce this dependence in the coming years.
Overall, we believe that EM growth will remain healthy and stronger than in the developed markets, but it will – and already is – slow alongside its developed market peers. In our view, this could be further exacerbated should the Eurozone experience a sharper-than expected recession.
2. Monetary (and fiscal) easing ahead
While we expect growth to ease in the emerging markets, most countries have more ammunition to combat this slowdown than in the West. Already, most EM central banks have started monetary policy easing, and we expect this trend to expand in the coming months. With Brazil in the lead – the central bank has indicated that rates are likely to fall to single digits from the current 10.5% – central banks have been pro-active in supporting their economies by cutting interest rates, and they are likely to continue to do so. Even in India, where inflation is still above target and may prove sticky, the central bank cut the reserve requirement ratio for banks, though interest rate cuts may take some more time to materialise.
In addition, due to their healthier government finances, EM policymakers could add fiscal stimulus to monetary easing, if the slowdown in the West was more pronounced than expected. This is one key difference with developed market economies, which are already facing high debt loads and therefore have very limited support options – in addition to the prospects of aggressive fiscal consolidation, which is likely to come at a high cost to growth to the West in the coming years.
In our view, interest rates cuts could have a significant positive impact on the performance of EM local currency debt in the coming months. Indeed, we could see more differentiation in performance between countries where inflation is falling faster and where interest rates cuts are likely to materialise sooner
and more aggressively, than in countries with sticky inflation.
For EM currencies, lower interest rates could mean less attractive carry compared to the developed markets, although we believe that EM rates have headroom above the West’s nearzero interest rate policy before this becomes a major stumbling block for EM FX. Expectations for the appreciation of EM currencies over the long run, including China, should also remain a support.
3. No more inflation?
One obstacle to easing policy in the emerging markets is slowly fading as inflation has been on a downward trend in recent months, with few exceptions such as Korea and India. Agricultural price inflation fell by approximately 8% in the last few months of 2011. With food prices representing the biggest part of CPI in most EM countries, we believe that inflation will continue to fall in the coming months. Indeed, Chinese inflation peaked in July 2011 at 6.5%, and has now fallen to 4.1% in December.
Further, we believe that the recent rebound in EM currencies should help contain inflation, allowing central banks
to cut interest rates. While EM policymakers have typically fought currency appreciation as they feared an impact
on export growth, we believe that they will allow the current strength to persist, as we are still below pre-summer levels.
As a result, we believe that the lower likelihood of intervention in currency markets could give more confidence to
investors in EM currencies.
4. Can EM assets beat risk-off?
Emerging market assets have shown strong performance since the start of the year, amid an improved risk appetite environment, but the question remains whether they can keep up these strong performances if we were to see a reversal in risk appetite.
Last fall, despite strong growth and healthy fundamentals, EM assets sold off with developed market assets, and we believe that EM will remain sensitive to Western developments in risk appetite. Nonetheless, we believe that historically cheap valuations and pro-active policymakers should provide underlying support to assets and help somewhat limit downside risks.
Nonetheless, we expect currency markets to remain volatile in the coming months, as many uncertainties continue to muddy the waters and we are unlikely to see a solution to Eurozone issues or growth worries in the short term.
The same applies to EM equity markets, which remain higher beta than developed market equities. In our view, there are risks to the current rally in the West, and any pullback in markets is likely to affect EM equities as well. We believe that higher beta markets, such as India, South Korea and Taiwan may be more vulnerable to risk appetite reversals. For example, the Indian market has had one of the best performances since the start of the year, but it is still well below early 2011 levels.
5. Valuations
Most EM assets have not been this cheap for a number of years, as their 2011 performance significantly impacted valuations. For example, EM equities fell 18% and the 12-month forward P/E of the MSCI EM index is about 10x compared to 12x for developed markets.
As expected, EM debt proved more resilient than equity and currency markets, with hard currency debt gaining 8.5% in 2011, helped by strong US Treasury performance, while local currency debt was flat. Local currency debt suffered from the currency component, which counterbalanced gains on the bonds.
Currently, EM hard currency sovereign bond spreads are around 420 basis points – wider than at the start of last year.
EM currencies had a difficult second part of 2011, with countries with a tougher fiscal position (current account deficits and high external debt levels) depreciating more than healthier currencies. This impacted, for example, TRY, ZAR, HUF and INR. In our view, currencies of countries with better fiscal positions will continue to see positive discrimination this year, such as Indonesia, Malaysia, Brazil and Mexico.
6. Flows
Following large outflows in the latter part of 2011, flows are moving back into emerging market assets. EM equity fund inflows are near their highest rate since April 2011, nearly reversing the outflows of the end of 2011, supported by risk-on mode since the start of the year. EM bonds have also seen inflows in recent weeks, as interest rate cuts in EM and improving currency performance have supported local currency debt and continued low yield expectations on US Treasuries are supporting hard currency debt.
Regionally, Asia is benefitting the most, followed by Latin America, while ongoing worries about the Eurozone are impacting the EMEA region. In our view, this trend is likely to persist, as Asian assets appear to be in the best position compared to their peers.
Our preferences and positioning
We maintain a relatively cautious outlook for emerging markets, despite their encouraging start to 2012. We believe that Western woes will continue to weigh on performance and that EM assets will remain hostage to changes in global risk appetite.
In this environment, we have a preference for hard currency debt in the short term, as we perceive it as the ‘safe haven’ among EM assets. We believe that EM hard currency debt is likely to prove most resilient – as in 2011 – in the case of a reversal in risk appetite. Further, we expect performance to remain attractive as we believe US Treasury yields will remain near current historically low levels and the spreads over Treasuries will tighten. In our view, EM hard currency sovereign spreads over-widened compared to their healthy credit fundamentals in 2011, providing an attractive opportunity for tightening in an improving
risk environment.
Many EM countries are receiving credit ratings upgrade and are now reaching investment grade status. This means that they will enter global bond benchmarks and should see further inflows as a result. Also, some countries continue to offer a spread compared to Western investment grade benchmarks, so, with the expectation of a narrowing of spreads in line with their peers, debt should appear attractive. A prime example is Indonesia, which obtained investment grade status at the start of the year.
For local currency debt, interest rate cuts are likely to be a key driver, although currency performance expectations will continue to impact demand for bonds, especially in a volatile environment. In the short term, we remain selective in our currency choices, although we maintain our conviction in EM currencies over the long run, especially if China continues its gradual (3% per year) appreciation of CNY, carrying other Asia currencies with it. In addition, as and when risk conditions improve, we could see the carry trade come back into vogue, given the prospects of near-zero interest rates in the West for the foreseeable future (the Federal Reserve has indicated it is likely to stay on hold until the end of 2014). Indeed, EM local currency bonds still offer a carry of approximately 5% over Treasuries.
We maintain our neutral view on EM equities, although we are starting to see some opportunities emerge in select countries. In our view, the higher beta nature of EM equities is likely to remain an obstacle to performance in the coming months, as we believe that ongoing risks will put a lid on risk appetite. Nonetheless, we believe that China (where growth should hold up), Brazil (which is benefiting from intra-EM trade), Mexico (and its exposure to resilient US growth) and Indonesia (with a strong domestic backdrop) are starting to offer attractive opportunities. Indeed, their domestic-oriented nature, their access to natural resources and the benefits of a Chinese soft landing should support these markets. In addition, we believe their position makes them less sensitive to Eurozone woes and less sensitive to global risk appetite.
