Risk Unrewarded as Emerging Stocks Lag Behind Most Since ’98
The link between risk and reward in stocks is breaking down as emerging markets post the worst first quarter since 2008 and lag behind shares of developed economies by the most in 15 years.
The MSCI Emerging Markets Index (MXEF)’s 3.8 percent drop this year through last week trimmed its rebound from an October 2011 low to 22 percent. That compares with a 33 percent advance for the MSCI World Index and marks the first time since 1998 that developing-country shares have underperformed during a global rally. When adjusted for price swings, emerging market returns are 37 percent smaller than in advanced nations, data compiled by Bloomberg show.
While higher volatility in developing countries led to outsized gains during the last six bull markets, this time is proving different as government intervention curbs profits at companies such as PetroChina Co. (857) and Light SA and growth slows from South Korea to Poland. Bulls say emerging markets will lead the next stage of the global rally as record low interest rates send investors into riskier securities. Pessimists say the trend will continue as investors favor more transparent markets.
“The old rules of thumb may need to be questioned,” Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., which oversees about $661 billion, said in a phone interview. “It is surprising to many investors that emerging markets haven’t participated in the rally.”
Money managers surveyed by Bank of America Corp. cut developing-nation shares in March for the first time in six months while boosting positions in the U.S. (SPX) to the highest level since July, Michael Hartnett, the bank’s chief investment strategist in New York, wrote in a March 19 report. Morgan Stanley, owner of the world’s largest brokerage, reduced its estimate for gains in emerging-market equities on March 18 while boosting its projections for U.S. and Japanese shares.
MSCI’s emerging index rose 0.6 percent at 4 p.m. in New York, after falling 2.6 percent last week. The MSCI World (MXWO) Index fell 0.4 percent to 1,426.61 after a 0.8 percent decline last week. The Standard & Poor’s 500 Index slid 0.3 percent to 1,551.69.
The 120-day correlation between the two MSCI gauges fell to an eight-year low of 0.54 on March 14. A reading of 1 shows lockstep moves, while minus 1 means opposite directions.
Investors willing to endure bigger price swings in developing nations have usually been rewarded during global stock rallies. Emerging shares beat developed equities by an average 46 percentage points during bull markets -- defined as a gain of at least 20 percent in the MSCI All-Country World Index (MXWD) from a recent low without a decline of the same magnitude -- since the index data began in 1988.
Now, developing markets are trailing after most of their companies missed analyst profit estimates for the last five quarters and economic expansions from China to Brazil slowed to the weakest rates since 2009. A majority of MSCI World companies beat earnings projections, while the pace of U.S. growth has rebounded to levels reached before the financial crisis.
The only other bull market emerging stocks lagged behind was from September 1990 through July 1998, a period when U.S. shares surged during the dot-com bubble and Asian (MXAPJ) equities were dragged down by the region’s financial crisis.
Volatility (EEM) in the MSCI emerging index was higher than that of the developed-country gauge during each rally, by about 30 percent on average, according to data compiled by Bloomberg. Emerging equities also posted steeper declines and bigger price swings than developed shares during bear markets, the data show.
The current rally suggests equity investors are still hesitant to take on risk, five years after the worst financial crisis since the 1930s sparked a contraction in the global economy and wiped out $37 trillion of stock market value, according to Wells Fargo Advisors LLC’s Scott Wren.
“It’s a safety play,” said Wren, the St. Louis, Missouri- based senior equity strategist at Wells Fargo Advisors, which oversees about $1.2 trillion. “People want to own stocks more than they did a while ago, but they want to be a little cautious.”
Brazilian shares led the decline in emerging markets this year, with the benchmark Bovespa Index (IBOV) falling 9.4 percent. Light SA (LIGT3), a Rio de Janeiro-based power distributor, tumbled 18 percent this year as President Dilma Rousseff cut electricity rates by as much as 32 percent in a bid to boost economic growth. Poland’s WIG20 Index (WIG20) dropped 8.2 percent as figures showed the nation’s economic expansion slowed for a fourth straight quarter in the period ended December.
Japan’s Nikkei 225 Stock Average (NKY) surged 19 percent in 2013, the biggest gain among 45 equity indexes in emerging and developed markets tracked by Bloomberg. Sony Corp. (6758), Japan’s biggest consumer electronics exporter, jumped 73 percent this year as Prime Minister Shinzo Abe took steps to weaken the yen and revive the economy with more expansionary monetary policies.
The Standard & Poor’s 500 Index advanced 9.2 percent since the end of December and closed last week at 1,556.89, within 1 percent of its all-time high. Citigroup Inc. (C), the third-biggest U.S. bank by assets, increased 14 percent this year as the Federal Reserve pledged to continue its unprecedented monetary stimulus and the housing market showed signs of a sustained recovery.
The U.S. Citigroup Economic Surprise Index, a measure of how much reports are exceeding economists’ estimates, rose to a two-month high on March 14 while the gauge for emerging markets shows reports have trailed projections since January.
“The U.S. has been delivering,” said Russ Koesterich, the chief investment strategist at New York-based BlackRock Inc., the world’s largest money manager with $3.8 trillion in assets.
Not all emerging markets are losing. Thailand’s SET Index has surged 73 percent since the current global rally began on Oct. 4, 2011, while the Philippine Stock Exchange Index (PCOMP) rose 70 percent. The Thai economy may expand by as much as 5.5 percent this year and the Philippines will probably grow at least 6 percent, according to government estimates. Economists surveyed by Bloomberg predict a 1.9 percent expansion in the U.S.
“These are emerging markets and they have flaws,” said Byron Wien, vice chairman of the advisory services unit at Blackstone Group LP, the world’s largest manager of alternative assets such as private equity. “They also have enormous economic momentum and the developed markets are mature and the momentum is not as pronounced.”
Wien said emerging markets will lead gains in global stocks this year with “double digit” returns.
Developing nations are becoming safer bets by some measures. Government debt has declined to 34 percent of gross domestic product from 52 percent a decade ago, according to the Washington-based International Monetary Fund. That compares with 110 percent in advanced countries.
Emerging markets have more than $6 trillion of foreign exchange reserves, data compiled by Bloomberg show. The extra yield investors demand to own their sovereign bonds over U.S. Treasuries has narrowed to 3 percentage points, or 300 basis points, from an average of 371 during the past five years, according to the JPMorgan EMBI Global Index.
“Relative to Europe and Japan, emerging markets do not have the same indebtedness problem,” said David Kelly, who helps oversee about $400 billion as the New York-based chief global strategist at JPMorgan Funds.
Developing stocks also have lower valuations. The MSCI emerging gauge trades for 10 times analysts’ 12-month profit estimates, versus 13 times for the MSCI World, the widest gap since November 2008, according to data compiled by Bloomberg.
In the biggest emerging markets, government interference is eroding returns for minority shareholders. PetroChina, which dropped 6.7 percent in Hong Kong trading this year, posted annual earnings that trailed analysts’ estimates on March 21 as the government capped retail fuel and natural gas prices to contain inflation.
Brazil’s Rousseff has intervened to curb utility rates, bank lending margins, mobile-phone fees and fuel prices -- reducing earnings prospects for industries with a combined weighting of about 50 percent in the Bovespa index.
OAO MRSK Holding (MRKH), a Moscow-based power distributor, tumbled 49 percent during the past 12 months as President Vladimir Putin delayed tariff increases and signed a decree to combine the company with state-run Federal Grid Co., instead of selling shares to private investors as some analysts had anticipated.
“The risk of the emerging markets is that the institutional frameworks are still a work in progress,” said Rupal Bhansali, who helps oversee about $5 billion as a New York-based chief investment officer for international equities at Ariel Investments LLC.
Inflation is preventing central banks in emerging markets from stimulating their economies as much as developed nations, said Jason Hsu, the chief investment officer of Newport Beach, California-based Research Affiliates LLC.
Consumer prices in Brazil rose at the fastest pace since December 2011 in February, spurring speculation that the central bank will raise its benchmark interest rate this year. People’s Bank of China Governor Zhou Xiaochuan said at a March 13 press conference that policy makers should be on “high alert” over inflation, while India’s central bank said on March 19 that scope for further monetary easing is limited.
By contrast, the Federal Reserve maintained its $85 billion-a-month bond purchase program on March 20 and Bank of Japan Governor Haruhiko Kuroda vowed the next day to pursue “bold” monetary stimulus.
“I can certainly see quantitative easing continuing” in advanced economies, said Andrew Milligan, who helps oversee about $264 billion as head of global strategy at Edinburgh-based Standard Life Investments Ltd. “At the margin, that’s going to support developed rather than emerging markets.”
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