Now is not the time to be piling into emerging market assets, according to a note by Gavekal Research, and investors might be better off waiting for a more attractive entry point in the future.
Emerging market equities have endured a tough time over recent years after being shunned by investors, with the MSCI Emerging Markets index underperforming the developed market-focused MSCI World in three of the past five full calendar years.
On a five-year view, the MSCI Emerging Markets index has made just 27.15 per cent in sterling terms while the MSCI World has surged 100.32 per cent. The emerging market index is also lagging the MSCI World over three- and 10-year time frames.
Performance of indices over 5yrs
Source: FE Analytics
This look very different over 12 months, however. Signs of stronger economic global growth and rebounding commodity prices buoyed investor sentiment towards cyclical assets and emerging markets were among those that rallied, as were key commodities such as copper.
FE Analytics shows the MSCI Emerging Markets index is up 48.87 per cent over one year compared with a 42.82 per cent gain for the MSCI World. This resurgence has prompted fresh investor interest in the asset class but Gavekal's Joyce Poon argues that the emerging market reflation trade is now “past it best”.
“The emerging market reflation trade has been on fire. This week Dr Copper broke out of his six-year downward trend, adding fuel to the reflationary flames. As a result, while the relative performance of cyclical stocks has moderated in developed markets during February, emerging market cyclicals have continued their bullish run,” she said in a note last week.
“Their strong performance has helped to lift the MSCI Emerging Markets index by 10 per cent year-to-date in US dollar terms to reach a 19-month high. But, now that the trade has become consensus, and with nominal bond yields now on pause, investors are beginning to wonder if the emerging market reflation trade is maturing.”
Supporting her view, Poon highlights the respective drivers of the equity rallies taking place in the US and emerging markets.
In the US, the equity market bull run has been driven mostly by policy expectations of tax cuts, deregulation and increased infrastructure spending – leading to the so-called Trump rally. Here, only limited support comes from macroeconomic fundamentals with most investors keeping their eyes on the policy plans of new president Donald Trump.
In emerging markets, however, the rally appears to be driven by a recovery in nominal economic growth and broadening earnings-per-share growth. Poon notes that “the end of producer price deflation, thanks to the upturn in commodity prices, means improved pricing power, better terms of trade and higher returns on assets for corporates”.
Performance of indices over 1yr
Source: FE Analytics
Economic data from emerging markets has been improving recently, the analyst also points out. Malaysia recently reported 4.5 per cent year-on-year GDP growth for the fourth quarter of 2016, the highest rate in a year; Indonesia has seen export growth jump from 16 per cent year-on-year in December to 27.7 per cent in January; and Brazil’s more aggressive monetary easing looks set to end the country’s two-year-long recession.
Presenting the bull case for emerging market, Poon said: “Putting all these factors together, we are looking at emerging market profit growth this year in the high single or low double digits. And if the strong US dollar leads to an expansion in the US current account deficit, as it has in the past, the emerging markets will enter a multi-year reflation period, in which a weakening US dollar perpetuates a virtuous cycle with a positive macro feedback loop providing support for risk-taking.”
However, she adds that there are plenty of things that could hamper this optimistic assessment of emerging markets and highlights three factors in particular.
First, the emerging market risk premium could be pushed higher by rising protectionism, which is one of the major risks associated with a Donald Trump-headed administration. Poon says there are a number of distinct ways a more protectionist stance in the US could affect the rest of the world and none would be positive for emerging markets.
“For now, however, investors remain blasé about the risk, with the market pricing a low probability that the US will impose either border tax adjustments or outright import tariffs,” the analyst said.
Secondly, faster-than-expected inflation would harm emerging markets if the US Federal Reserve fell behind the curve at the same time the government was embarking on fiscal stimulus. “In that event, the market might over-tighten financial conditions,” Poon said. “That would come as a rude awakening for leveraged bond market plays, raising the cost of funding for EM borrowers, who have been especially active in the market over recent years.”
Performance of oil and copper over 1yr
Source: FE Analytics
Finally, there is the risk that the commodity price recovery could run out of steam. The Gavekal analyst says that the market is expecting factors such as Chinese capacity reductions and housing boom to continue supporting prices, but warns these could disappear and cause commodity weakness.
“In summary, the balance of risks has shifted. For the rally in emerging markets to continue, a lot has to go right. On the other hand, it may only require one thing to go wrong for the run-up to falter,” Poone concluded.
“As a result, although the markets could continue to test the upside in the immediate future, I expect emerging market returns to be capped, with emerging Asia now only a few percentage points from issuing a sell signal. The emerging markets rally has passed its best. Investors should look for a more favourable entry point later in the year.”