Fate of Emerg­ing Mar­kets hangs in the bal­ance

Financial Mirror (Cyprus) - - FRONT PAGE -

The Chi­nese econ­omy is in the process of a 180-de­gree tran­si­tion from an ex­port-ori­ented pow­er­house to an econ­omy which is fo­cused on ser­vices, man­u­fac­tur­ing and the ur­ban­i­sa­tion of mil­lions of peo­ple. This del­i­cate bal­anc­ing act ap­pears to the world un­der the guise of struc­tural weak­ness, but it is noth­ing more than a re­bal­anc­ing of the Chi­nese econ­omy which will lead to long-term growth. In the short to medium-term (1-5 years) there is no doubt that pres­sure will be main­tained on the economies of emerg­ing mar­kets from the Asia-Pa­cific re­gion, to Africa and Latin Amer­ica. Chi­nese de­mand for raw ma­te­ri­als and other re­sources, no­tably en­ergy and min­ing, has di­min­ished. This has been re­flected by the de­clin­ing GDP fig­ures for De­cem­ber 2015, and the year that passed. That China’s an­nual GDP dropped to 6.9% for 2015 is no­table, and it is the worst per­for­mance of the world’s se­cond-largest econ­omy in decades.

This news has sparked tremen­dous con­cern among fi­nan­cial en­ti­ties in­clud­ing Gold­man Sachs which re­cently an­nounced that pres­sures in China will likely lead to five years of eco­nomic hard­ship for emerg­ing mar­ket economies. The global in­vest­ment en­ter­prise cau­tioned its clien­tele to read­just their fi­nan­cial port­fo­lios to limit their ex­po­sure to emerg­ing mar­kets. This trend has been tak­ing place for quite some time and is ev­i­dent in the de­clin­ing share of Asian eq­ui­ties, African eq­ui­ties and South Amer­i­can eq­ui­ties in the fi­nan­cial port­fo­lios of clients. In­vestors have been cau­tioned to con­sider the facts when con­tem­plat­ing in­vest­ing in emerg­ing mar­ket economies: Rus­sia, China and Brazil are bear mar­ket economies and their per­for­mance from April 2011 to mid-Jan­uary 2016 has re­vealed a -40% re­turn. Com­pare that to a +44% re­turn for US eq­ui­ties and it is clear where the safe money re­ally lies.

The ques­tion is: why are emerg­ing mar­kets far­ing so badly? For one, the US dol­lar has con­sis­tently per­formed above ex­pec­ta­tions. The US econ­omy has shown in­creas­ing strength over time with un­em­ploy­ment drop­ping to 5%, growth con­tin­u­ously inch­ing higher and in­fla­tion slowly but surely mov­ing to­wards the bench­mark rate set by the Fed­eral Re­serve Bank. All of th­ese fac­tors com­bined with the De­cem­ber 16 rate hike by 25-ba­sis points to 0.50% for the fed­eral funds have re­sulted in a bleak out­look for EM cur­ren­cies and a bullish out­look for the USD. But the big stinger for EM economies is weak global de­mand brought on by China weak­ness. Com­mod­ity prices, no­tably crude oil, have been ham­mered in 2015 and pum­melled in the first three weeks of 2016. Crude oil crashed through the crit­i­cal $30 per bar­rel sup­port level in the third week of Jan­uary, but bounced back on Fri­day to set­tle above $31 a bar­rel as bullish sen­ti­ment from the Euro­pean Cen­tral Bank and the Chi­nese au­thor­i­ties helped to stem the rout.

So se­vere is EM weak­ness that the MSCI ACWI (the global stock mar­ket in­dex) has slid into bear mar­ket ter­ri­tory. De­clines had reached 20% across the board by Wed­nes­day, Jan­uary 20. Other ex­change traded funds such as the Sch­wab EM Equity Fund de­clined a full per­cent­age point in Q4 2015 and lost as much as 16% dur­ing the course of 2015. None­the­less, it is not all doom and gloom for emerg­ing mar­kets over the long-term, but now is def­i­nitely not the time to see sub­stan­tial gains be­ing gen­er­ated as fur­ther set­backs are likely to take place be­fore the even­tual turn­around in years to come. If we look at things like val­u­a­tions, it is clear that the P/E ra­tio for EM eq­ui­ties has con­sis­tently un­der­per­formed the P/E ra­tios of de­vel­oped econ­omy eq­ui­ties by a fig­ure of 20%. There was a pe­riod dur­ing which EM stocks proved to be highly valu­able in­vest­ments, but that was be­tween 2000 and 2007.

In terms of val­u­a­tions, the lower the num­ber the bet­ter the value for the stock, but volatil­ity may be a fac­tor. Con­sider th­ese stocks and their as­so­ci­ated val­u­a­tions: - The P/E ra­tio for In­dian stocks hov­ers around 19 - The P/E ra­tio for Chi­nese stocks hov­ers around 57 - The P/E ra­tio for the MSCI South Korea in­dex hov­ers around 10

One can­not ig­nore the deeper im­pli­ca­tions of a Fed rate hike on the EM economies. The sta­bil­ity that coun­tries like the US and Canada have is far more than mere cur­rency as th­ese classes. strength brought upon by a rate in­crease; the strength of the US econ­omy is struc­turally­based, and is fully com­pli­ant with reg­u­la­tory re­quire­ments. The prob­lems in de­vel­op­ing coun­tries in­clude political in­sta­bil­ity, struc­tural weak­ness, lack of an ef­fi­cient and ef­fec­tive eco­nomic frame­work and high volatil­ity. In the case of South Africa, there are also other con­cerns such as a fail­ing power grid which crip­ples the econ­omy.

But the weak­ness in emerg­ing mar­kets is un­likely to last in­def­i­nitely. As a case in point, the ag­ing pop­u­la­tion in China will likely give rise to a grow­ing middle-class which will re­quire health care in the next decade. This will open up the phar­ma­ceu­ti­cal sec­tor in a big way. The Chi­nese mar­ket may well be­come the world’s se­cond most lu­cra­tive phar­ma­ceu­ti­cal mar­ket, de­spite weak­ness in com­modi­ties. In­vestors who adopt a strate­gic ap­proach to EM economies are un­likely to be dis­ap­pointed as growth is bound to take place economies grad­u­ally de­velop their own middle Saudi Ara­bia -21% Ar­gentina -19% Egypt -18% Rus­sia RTS -17% Greece ATHEX Com­pos­ite -17% SSE Com­pos­ite -16% FTSE MIB -15% Nikkei -14% Chi­nese eq­ui­ties, for ex­am­ple, are not cheap at all, and they need to un­dergo ad­di­tional weak­en­ing be­fore any value can be gained. Be­tween 2016 and 2020, Chi­nese eq­ui­ties could weaken by up to 8% a year be­fore they come in line with cor­rec­tive val­u­a­tions. More con­cern­ing to EM economies is the fact that China will likely de­value its cur­rency to re­main com­pet­i­tive in ex­port mar­kets. This will mean that China will be un­der­cut­ting its com­peti­tors which are largely EM economies. For now, the smart money is on the de­vel­oped economies of the Eu­ro­zone, Ja­pan, the US, Canada and other Asia-Pa­cific western coun­tries.

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