Emerging market investors were upbeat at September’s IMF-World Bank meetings, and their optimism at first sight appears justified. Almost all performance benchmarks for the diverse bond and stock asset classes are showing double-digit annual gains.
At the same time, institutional and retail fund allocation has sharply reversed from net outflows in early 2016 to inflows of more than $50bn in the third quarter. These developments reflect how sentiment towards the US, Europe and Japan has turned sharply lower over banking, political and monetary policy concerns.
However, the bullish argument for emerging markets should only be applied to a subset of countries and asset classes. An across-the-board spike has historically signaled that both fundamentals and valuations are overdone.
The sober economic background may have changed incrementally and relatively from previous pessimism, but hardly screams “buy.” Of the Brics group of emerging markets, Brazil, Russia and South Africa are likely to avoid recession. China is on course to achieve its 6.5% growth target for 2016, and India will expand faster still. According to estimates by the International Monetary Fund and World Bank, the average rates for growth and inflation across emerging markets currently stand at around 4%, fueled by higher fiscal deficits and negative real interest rates. Deleveraging has cut credit creation to single digits, reports the Institute for International Finance, though China remains a notable exception.
A recovery in emerging market currencies could hamper exports already hurt by flat global trade, while declining remittances may contribute to a further deterioration in current accounts. And while capital outflows have abated in Russia and China, they remain prominent in the rest of Asia, Europe and Latin America. Commodity prices have partly recovered, but they remain a long way from their former peaks.
From a valuation perspective, the price-to-earnings ratio discount to developed country equities has narrowed to a minimum, while sovereign bond spreads over US Treasuries are near their record low. The corporate debt market is in similarly poor condition. Ratings downgrades significantly outnumber upgrades, and high-yield issuer defaults are already 5% of the total.
In developing markets listed companies are often state-owned and confined to ‘old economy’ industrial and financial sectors. With current bond appetite and new entrants, government and corporate international issuance is expected to be 50% higher in 2016 than projections indicated earlier in the year. Any resulting oversupply will further cramp yields, already below 6% for local currency instruments, according to JP Morgan.
Attempts to analyse emerging markets as a whole overlook vast differences at the country level. The IMF reminded participants at the September meetings of rescues underway in Ghana, Egypt, Mongolia and Serbia. Nigeria, a leading frontier market, has been removed from JP Morgan’s bond index, and could soon be removed as an MSCI share component. China’s rehabilitation of its economic and banking system is slow-moving. The addition of the renminbi to the IMF’s special drawing right basket, along with tie-ups between the Shanghai and Shenzhen stock exchanges and Hong Kong, have also failed to remove underlying policy doubts.
Even traditional investor favourites such as Mexico, Poland and South Korea have been tarnished by a combination of leadership overreach, budget laxity, and institutional investor weakness. Despite rating agencies’ cuts, these warnings seem to have been ignored.
Compelling stories of emerging market change, accompanied by steps to deepen debt and equity bases, are few in number. These concerns should come into focus as the relief rally of the past several months fades. Some buoyant investment destinations remain, including Hungary, Chile, Indonesia, Romania, Peru, and Pakistan. But investors need to pick their asset categories carefully as they embark on a more genuine journey of rediscovery.