Investors have been offloading emerging-market assets in droves based on a number of factors, particularly economic growth fears and US dollar strength. Whether such broad-based aversion is merited is open to question.
In August the Institute of International Finance (IIF) estimated EM outflow at almost $300 billion, based on data from the previous four quarters.
Although large, it was less than a third of the startling $1 trillion outflow figure over the past 13 months published by the Financial Times. “Don’t panic! EM capital flows have weakened, but not collapsed,” stated the IIF.
Jan Dehn, head of research at EM-focused Ashmore Investment Management, noted that its calculation of outflows – between $183 billion and $295 billion – amounted to less than 0.9% of total tradable debt and equity in the EM universe.
“Ignorance and prejudice about EM are rife,” he seethed. “When combined they can become dangerous. When they fuel misleading, sensationalist media headlines they remind us there is no substitute for independent thinking when it comes to EM.”
Because they are less liquid than developed markets, EMs are more sensitive to broad-based selling by short-termist retail and high-net-worth investors via mutual funds and exchange-traded funds.
Diminished liquidity and consequent price volatility will deter institutional investors from providing the sort of long-term capital these markets crave. Hence Dehn’s sensitivity.
Notwithstanding his commercial motivation as a big EM investor, Dehn urges perspective. Emerging markets comprise 57% of global GDP, he notes, but account for less than 15% of tradable debt.
He seeks to explain the reasons behind global investor nervousness that now sees global equities only neutrally valued (average yield 6.4%) even as “risk-free” global sovereign bonds (average yield 1.1%) are so expensive.
Dehn pins the blame on prolonged quantitative easing policies that have underpinned the performance of developed market trades such as US stocks and core US dollar and European government bonds.
Of course, such trades have suffered in 2015, with US stocks down (S&P500 Index -0.72% year-to-August 28), the US dollar index DXY down 4.2% from March and core European bond markets suffering big losses since April.
At the heart of these falls lie the strengthening US dollar and zero-to-negative yields. Dehn suggested the thing that no-one ever imagined could come to pass, “namely that limits to what hyper-easy monetary policies can achieve has happened. If the drugs no longer work, what’s next?”
He argued policymakers had squandered the good times for developed market assets over the past four years by not undertaking sufficient deleveraging and reforms.
“Now we are stuck with overvalued asset prices, weak, unproductive and heavily indebted economies and no obvious way forward,” Dehn noted. “These huge uncertainties cloud the outlook for returns in developed markets and, as per normal, adversely affect sentiment towards EM.
“But it is developed markets, not EM, that are over-indebted, slow growing, money printing and unable to reform. They are also the more expensive markets, by far.”
Valuation vs earnings
On a valuation metric, emerging market equities are currently trading at a 35% discount to developed market equities based on the trailing price-to-book metric. But presumably it is doubts over earnings that are causing investors to panic, given that global emerging markets are dominated by commodity producers and commodity prices have collapsed.
The Bloomberg Commodity Index of 22 raw materials from oil to metals closed at 85.85 on August 24, its lowest level since August 1999 – before the 2000s commodities boom. It had risen slightly to 88.78 at press time on August 31.
Investors have been overweighting developed markets due to the fall in commodity prices, and with demand lower in the West, they are not expecting to see an earnings pick-up in EM anytime soon.
Nicholas Ferres, investment director for Eastspring’s global asset allocation team, noted that while the EM index was trading at about 11 times earnings, it typically troughs at eight times. There’s more room to go down from here.
While EM credit spreads (both dollar and local) are above average, outright yields are still only neutral from a historical context.
Ferres added that foreign ownership in local bond markets was typically between 15% and 35%, meaning they are very vulnerable to sell-offs. Malaysia is 15% and Indonesia 30%, for example.
“This could exacerbate the [EM] correction, despite much stronger external positions [on average] relative to history,” said Ferres. “Maybe the growth scare in emerging markets is broadening out and could be self-fulfilling.”