Luca Paolini, chief strategist at Pictet Asset Management, asks whether fears for emerging markets are overblown...
The sell-off that knocked emerging markets last year threatened to take a dangerous turn in early 2014, as Argentina’s decision to devalue the peso in January triggered further sharp declines in markets across the developing world.
Yet, while a reassessment of emerging market dynamics was due, the seeds of this correction were sown some time ago. This carries significant investment implications. Stage one of the reality check occurred in 2010, when deterioration in the growth trajectory of developing economies took root.
Global economic activity had peaked and China’s growth started to moderate. So began a steady but persistent narrowing of the growth differential between the developing and developed world.
Putting the EM sell-off in perspective
As weaker growth translated into weaker corporate profits, a valuation gap began to emerge between both markets’ stocks; one that now stands at 30%, the deepest discount since 2005.
The next phase unfolded when the US Federal Reserve revealed a plan to unwind its quantitative easing programme in May and bond yields began to move higher across the developed world.
It was at this point the sell-off began to spread to emerging bonds and currencies: the narrowing of the yield differential between developing and developed debt and currencies was the excuse investors needed to retrench.
However, it is the next chapter of the market’s decline – the unmasking of the structural frailties inhibiting the advancement of many emerging nations – that is perhaps most important for investors to understand.
These vulnerabilities fall into three main categories: governance standards, financial market breadth and economic structure. From the broadening corruption probe in Turkey to the popular uprisings in Ukraine and Thailand, political and institutional frameworks across developing nations remain weak by ‘affluent world’ standards.
Indeed, the World Bank’s governance indicators show developing economies have, in aggregate, consistently failed to close the governance gap with developed nations over the past 15 years.
Developing countries also suffer from economic imbalances that have, in part, served to weaken current account positions. Emerging economies are notably less diverse than advanced ones, as shown by the composition of their exports.
The goods and services sold abroad by developing countries are, on average, concentrated in 50% fewer product categories than those of the developed world.
This can have a negative effect on countries’ current account positions during periods of market stress. An unsustainable expansion in private sector borrowing also contributes to current account weakness.
This has proved to be the undoing for countries such as Ukraine and Turkey, where private borrowing has been running ahead of savings at an alarming rate.
Nonetheless, it would be wrong to assume this sell-off will morph into a re-run of the Asia-inspired turmoil of 1997. The adoption of flexible exchange rates by many emerging economies is one development that materially reduces the potential for a fully-fledged crisis.
As the rapid improvement in Indonesia’s balance of trade shows, currency depreciation offers the developing world a handy escape valve that can facilitate an economic rebalancing.
Moreover, emerging market asset valuations are increasingly at odds with underlying fundamentals. When comparing emerging companies’ long-term earnings potential to such stocks’ P/E ratios, the asset class looks undervalued. It is a similar picture in emerging currencies, which, by our estimates, are trading around one standard deviation below their fair value.
Yet, investors would do well to become more discerning than they perhaps were in the past. The stocks, currencies and bonds of countries that possess weak current account balances, lack a loyal domestic investor base and shy away from institutional and economic reform will probably trade at a deeper discount.
India offers a clear example of how reform can pay. Hit hard in 2013, the Indian rupee has proved more resilient in recent months, as policymakers have raised interest rates and planned for the adoption of a more transparent framework centring on controlling inflation.
Policy responses such as these, combining anti-crisis measures with deeper reforms, should leave emerging market investors more encouraged about the future.
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