The MSCI Emerging Markets index (net of withholding tax) fell by 15.1% in US dollar terms from its peak on 26 January to the end of the second quarter (29 June). Although we continued to voice our support for EM equities on fundamental and valuation ground at the end of January, we were cognisant that the market had enjoyed a spectacular 2017 and a superb follow-on rally into the first weeks of the new year. We also acknowledged that markets tend to consolidate gains of this nature. Sure enough the consolidation came - and has continued with increasing intensity.
The drivers of this inevitable consolidation include:
Interestingly, developed market (DM) growth differentials have risen relative to those of the EM complex during the first calendar quarter, partly justifying modest liquidity flows tilting back to DM. This is especially so on the DM debt side as the yield on 10-year US treasuries (UST) broke through the 3% level, encouraging “search for yield” investors back to US bonds versus US equities.
US growth remained positive as US infrastructure and tax stimuli worked their way through to the reality of stronger economic growth and higher UST terminal Fed Funds rates for this cycle. New UST 10-year consensus target rates of 3.5% rose to 4%.
As a result, sentiment fell for all marginal assets.
The above factors led to an inevitable consolidation in the extended EM cyclicals, with the exception of select commodity plays such as oil (which drove through USD 80 on Iraqi and Venezuelan supply-side arguments). Meanwhile, the most vulnerable carry trade currencies slid harshly - Turkish lira, Argentine peso and the South African rand to name a few. “Risk-off moves” also permeated better quality positive carries - Brazilian Real / Mexican peso and Russian rouble. This is less intuitive since the latter two countries are beneficiaries of higher oil prices.
Nevertheless, we still feel confident that both fundamentals and valuations are supportive for EM Equities into the next 6-9 months. Price and valuation pullbacks have combined to give us some appealing re-entry points.
We expect the headwinds of dollar strength to soften, and the expectations / reality of a UST 10 year above 3.25% to be fully discounted soon. The resilience of EM credits is being tested and such a severe taper tantrum would in 1994, 1998 or 2004 have resulted in 50% falls in EM equities. This is a mild consolidation in comparison and is testament to the fact that eight out of the top ten EM economies are now investment grade (versus two and four countries respectively in 1998 and 2004).
The investment grade argument is also applicable to the composition of the MSCI EM equity index, with China, Korea, Taiwan and the core Gulf States - all of which are investment grade with solid international reserves, foreign direct investment (FDI) flows and favourable external balances – collectively constituting 60% of the index. At the industry level, the index weighting to metals, mining and energy is below 15% and hence less dollar sensitive than used to be the case. Credit levels at the individual and sovereign levels are also materially higher than 10 year norms.
There are, as always, countries that are vulnerable to dollar EM debt flow reversals, which have grown that liability risk too fast, post the GFC credit crunch. It is this vulnerability that has differentiated the strong positive carry trades versus less strong in this sell-off.
Nonetheless, with certain a Turkish banks offering 5% yield and trading at a very moderate price / earnings ratio (PER) of just 2.5x there is a price for everything. These are distressed valuations - even accounting for the equity being Turkish and the associated lira currency risk.
So, in overall terms, we are bullish on EM equities 6-9 months out and intend to use summer ‘taper tantrums’ to add to bombed-out, better quality cyclical currencies and stocks. We believe there is a lot more to come in 2018 for EM equities with growth in earnings per share (EPS) of over 18% anticipated as well as a significant PER re-rating from depressed levels. Positive free cash flow (FCF), a growing dividend yield and compelling price to book (PB) valuations, relative to US equities in particular, should also lend further support.
These metrics could not possibly be described as sell indicators and we would advocate ‘buying the panic’ on a selective basis.