NEW YORK (Reuters) — Emerging markets
were facing headwinds going into 2014, but January's rout surprised
even the gloomiest of investors, with big declines in stocks, bonds
and currencies.
Political turmoil and terrorism threats across market capitals from
Ankara to Kiev, along with growing concern about bad debt in China's
shadow banking system, caused a full-scale pullback across all risk
assets.
As a result, some investors are starting to see attractive values in
these markets. Sentiment remains weak, however, so the actions of
emerging market policymakers will determine whether investors take
advantage of low valuations or opt to preserve capital, strategists
say.
"From our view, the valuations in this sector, be it hard currency
(debt), local currency (debt), EM FX, corporates, are becoming
compelling. Look, that is the first time I have been even close to
bullish on emerging markets for a while. But it is on a relative
risk/return basis," said Paul DeNoon, senior debt portfolio manager
at AllianceBernstein in New York.
"The market has discounted a lot of bad news. I think with a lot of
policy responses in the better countries, some opportunities have
developed," he said, pointing to relative value in Indonesian,
Brazilian and Turkish credits which have fallen far and fast.
In just a month, the broad MSCI Emerging Markets stock index is down
7.5 percent versus a decline of 5 percent for all of 2013, a year
when developed markets surged by 30 percent. The benchmark U.S. S&P
500 stock index is down 3.6 percent year-to-date.
Yield spreads between emerging market sovereign debt and comparable
U.S. Treasuries widened by nearly 50 basis points, according to
JPMorgan's benchmark indices, the largest one month increase since
June of last year when the Fed's first hint at reducing its monetary
stimulus rattled global markets.
PLAYING DEFENSE
Turkey, India and South Africa have recently surprised markets with
aggressive defenses of their currencies. Their actions come as the
Fed moves toward more normal monetary policy that will cause less
money to move abroad in search of higher returns.
Emerging market currencies have lost ground against the U.S. dollar
and the euro. Bank of America Merrill Lynch (BAML) research said
that in aggregate, emerging market currencies are now undervalued by
about 2 percent, a sharp swing from 2010-2013 period when they were
considered overvalued.
The bank sees cheap medium-term bonds in South Africa and Brazil.
Mexico, Poland, Hungary and Malaysia look to be fairly priced, they
said.
The aggressive rate hikes from central banks in troubled countries
could stabilize those currencies, but it comes at a cost. Higher
rates could slow growth in certain countries that are already
struggling, and the weak demand from China means it will be more
difficult for countries to export their way out of trade imbalances.
As fundamentals have not improved, emerging market countries with
negative balance of payments metrics are in danger of more
underperformance in their currencies.
"Our EM strategists believe some EM equity markets have further to
fall, and that they require significant current account rebalancing
before bottoming," wrote Goldman Sachs.
STOCKS SUFFER
The Institute of International Finance wrote in its latest capital
flows report on emerging markets that the asset class now has a
price-to-earnings ratio for the coming 12 months, which gives a clue
as to future corporate earnings, at about 9 times, below the decade
average of 11 times. By comparison, developed markets are trading at
a forward P/E of 15, above the long-run average of about 13 times
earnings.
"Overall emerging market valuation has now fallen to very low
levels," the IIF wrote on Jan 30.
To be sure, the IIF cautions that not every market is going to
rebound. Many emerging markets — such as the now-famous 'fragile
five' — face challenges in implementing structural reforms. These
five — Brazil, India, Indonesia, South Africa and Turkey — are
considered the emerging nations with the weakest balance of payment
positions and most monetary policy uncertainty.
"The broad weakness in expected earnings over the next 12 months
(with only China expected to see much pickup) is another warning
that 'cheap' may not translate to 'rally' any time soon," the IIF,
an association representing big banks, wrote.
Those countries have responded, to a point. After Turkey's central
bank hiked its benchmark interest rate by 425 basis points, BAML
said it is time do some "serious bottom fishing in Turkey."
"We think it's now right to be overweight on a full 2014 view," BAML
said.
In addition to Turkey, central bankers in India and South Africa
have taken aggressive action, which one veteran EM analyst said will
be the deciding factor going forward.
"Policymakers could change valuation perceptions," said Daniel
Tenengauzer, head of Americas research at Standard Chartered in New
York.
He points to India's aggressive tightening, which stemmed the rout
that country's markets experienced in the last six months. In that
time India's benchmark BSE index has surged nearly 18 percent from a
spike lower in August 2013.
In Latin America, he sees the acute selling of stocks such as
Mexican telecoms giant American Movil, down 6.2 percent
year-to-date, as the result of Mexico's reforms, not just global
factors.
Mexico has undertaken major reforms across multiple sectors. In the
long-run reforms are positive but for companies like American Movil
the near-term challenge will be a negative for its bottom line.
Currently, the telecom company's P/E ratio is 11.3 on a forward
12-month basis versus its peers who are trading at 13.6 times
earnings. The stock is down 6 percent in 2014, putting it at a 17
percent discount to its peers, according to Thomson Reuters data.
Strategas Research Partners believes Mexico is primed for more gains
given reforms and its proximity to a strengthening U.S. economy.
The firm also believes Emerging Europe is poised for growth, citing
in particular, Poland's promising prospects of a so-far resilient
currency, low inflation, easy credit, and lower risk of capital
flight. MSCI's Eastern Europe stock index trading against the MSCI
Europe index, on a relative 12-month forward P/E basis, is below its
long-term average, they said.
(Additional reporting by David Gaffen;
editing by Andrew Hay)
