Trade of Decade or Value Trap? Emerging Markets Debate Heats UpBy
Bulls say valuations are getting too cheap to ignore
Bears point to weak growth, rising leverage, policy risks
The great emerging markets debate is heating up.
In the bull camp, money managers from BlackRock Inc. to Franklin Templeton made the case this week that valuations in developing nations are too cheap to pass up. Research Affiliates LLC said buying now could become the “trade of a decade,” after the benchmark stock index dropped 30 percent over the past three years and local-currency bonds lost 26 percent.
Bears, meanwhile, are worried about weak economic growth, an unsustainable corporate debt burden and bad government policies. Societe Generale SA and UBS Group AG have both warned that declines in emerging-market assets may have further to go.
Here’s a look at some key points on each side of the debate, starting with the optimists:
Emerging-market shares have only been cheaper than today’s level six times, based on cyclically adjusted price-to-earnings multiples tracked by Research Affiliates, a threshold that preceded average five-year returns of 188 percent. The benchmark index trades at a 28 percent discount to its advanced-nation counterpart, according to forward price-to-earnings ratios compiled by Bloomberg.
In the bond market, emerging economies stand out in a world where more than $7 trillion of global government debt guarantees negative returns when held to maturity. The extra yield on emerging-market dollar bonds over U.S. Treasuries climbed to a seven-year high of 5.07 percentage points this month. Brazil’s real-denominated debt yields 14.8 percent on average, giving foreign investors a sizable cushion against the risks of default or currency depreciation.
Some challenges facing developing economies have stopped getting worse. Oil prices now show signs of stability after falling more than 60 percent over the past two years, while China has stepped up efforts to support growth. Expectations of further interest-rate increases from the Federal Reserve have been tempered and the dollar’s rally has lost some steam.
With “many of the market ‘negatives’ accounted for, it is time to concentrate on some of the ‘positives,’ which we see gaining strength as market drivers going forward,” analysts from BlackRock’s emerging-market team wrote in a note this week.
Investors have dumped developing-nation assets indiscriminately in the selloff, according to Michael Hasenstab, Franklin Templeton’s chief investment officer for global macro.
Countries such as Mexico, South Korea, Malaysia, Indonesia and the Philippines enjoy “solid fundamentals,” but are treated as if they were in a crisis, Hasenstab, who manages the $53 billion Templeton Global Bond Fund, said in a blog post on Feb. 22. That creates a “fantastic opportunity” for investors, he said, adding that he’s avoiding Turkey, Russia, Venezuela and South Africa.
For bears, cheap valuations aren’t enough to spur a rebound as the outlook for global economic growth deteriorates. Citigroup Inc.’s Economic Surprise Index shows that indicators from jobs to manufacturing in developing nations have fallen short of analyst expectations since January.
With global trade stagnant, emerging economies aren’t getting a lift from exports. Overseas shipments from South Korea tumbled 19 percent in January, while China’s sank 11 percent. Central banks from Mexico to South Africa have raised borrowing costs to stem inflation, while capital outflows from China have prevented monetary authorities from cutting benchmark lending rates to prop up growth.
“It is too early to position for a sustained reversal in the EM depreciation trend,” strategists at SocGen wrote in a note Thursday.
A rising debt burden, including more than $2.8 trillion of foreign-currency borrowings in major developing economies, will weigh on emerging markets, according to UBS.
Weak earnings and tighter lending conditions are making it more difficult for companies, including state-owned enterprises, to repay their debt, according to Bhanu Baweja, the head of emerging-market cross-asset strategy at UBS. That may prompt governments to provide financial support via state banks, damaging their own balance sheets and boosting borrowing costs for everyone in those countries.
“A negative loop between financials, sovereigns and corporates may be set in motion,” Baweja wrote in a note earlier this month. He said emerging-market corporate bonds will underperform U.S. high-yield debt and that the developing-nation stocks may decline by 10 to 12 percent.
A lack of progress in reducing the state’s grip on emerging economies will continue to weigh on asset prices, according to John-Paul Smith, one of few strategists to anticipate the slump in emerging markets that began in 2011.
An example is Brazil’s inability to move on from “state capitalism,” which has helped plunge the economy into its worst recession in a century, said Smith, the founder of research firm Ecstrat Ltd. He also worries about Russia, Turkey and Poland, where he says policy makers are moving in a more “authoritarian” direction.
“If there is a historical analogy for emerging markets at the present time, it’s with the 1997-98 period,” when financial crises swept through Asia and Russia defaulted on its debt, Smith said in an e-mail on Thursday.
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