Pressure on emerging market growth will likely intensify in 2012 and there is little alternative to being overweight China, India and Malaysia, reckons ING Investment Management.
It comes after a recent survey of 450 financial advisers globally conducted by Royal Skandia, which saw Asian/emerging market equities handsomely top the voting for likely best performing asset class over the next 12 months.
Overall it took a year-and-a-half of eurozone troubles and six months of concerns over a hard landing in China for net capital flows to emerging markets to turn negative, as they did in the final quarter of 2011, notes Maarten-Jan Bakkum, GEM equity strategist for ING Investment Management.
High-risk markets, in particular, including Turkey, Brazil and Indonesia have endured outflows recently, with poor global risk appetite affecting portfolio flows as well as capital repatriation to the fragile European banking system.
“Given the weak outlook for global growth and the problems in Europe, we should prepare ourselves for more weakness in emerging market flows,” suggests Bakkum.
He cites past crisis periods as a lesson that once flows turn negative, emerging market equities struggle to perform, and points out that equities get hit directly as the dollar value falls due to local currency depreciation. He adds that if currencies decline by a substantial amount, inflation tends to increase and interest rates will have to be hiked.
This explains why he feels uncomfortable with policy easing in countries where currencies have been under pressure, inflation is high or where economic growth has been sustained by large speculative capital inflows.
He picks out Turkey as the first country to overplay its hand with regard to monetary easing at the end of 2010 and the first half of 2011, forcing the central bank to tighten policy dramatically a month ago.
He also expresses concern about Brazilian authorities cutting interest rates and taxes after the real came under pressure, while noting that inflation in Brazil is above the 6.5% upper limit of the central bank’s target range.
“We consider flows to Brazil as the most vulnerable in the GEM universe, and the real, which is still the most overvalued currency in GEMs, has the most downside risk attached to it,” says Bakkum.
He also expresses worries about policy easing in Indonesia, where the central bank has spent $13 billion in foreign exchange reserves to prevent the rupiah from weakening too much. “In times when foreigners are repatriating capital, it is a risky strategy to reduce the reward of holding Indonesian paper,” reflects Bakkum.
ING IM expects policy easing to be a key theme for 2012, adding it will be important to determine which countries can afford to cut rates or increase spending in an environment with considerable global headwinds.
“We believe that several countries have been moving too much, too fast,” says Bakkum. “They might be forced to change course later in 2012. Turkey set the example. Brazil and Indonesia might follow suit.”
Meanwhile, he notes that the room for China and India to stimulate domestic demand has been increasing. In China, where growth has been slowing and inflation finally coming down, the government can now become more decisive in its efforts to push investment growth higher.
Meanwhile India’s central bank has considerably more room than most counterparts in emerging markets to cut rates, and ING IM is forecasting a rate cut early next year, with up to 150 basis points of cuts next year.
“If China and India act decisively in the next few months, they are still likely to avoid a sharp contraction in domestic demand growth,” says Bakkum.
For China, ING IM is predicting GDP growth of 7.8% next year, with 7.1% for India. For emerging markets as a whole, its growth forecast for 2012 is 5.4%, implying that growth outside of China and India will be far below potential.
Bakkum notes that in this environment he does not see a good alternative to being overweight China, India and Malaysia, the former two because of declining inflation and room for policy easing and the latter for its defensive characteristics.
He expects more EM currency weakness in 2012 and limited room for EM authorities to stimulate economic growth; growth in the emerging world is likely to disappoint, he adds. While current valuations look attractive at first sight, he suggests expectations for next year’s EM earnings growth are still on the high side, at 7% in US dollar terms.