We are at the end of an exceptionally long and strong global economic, equities, credit and property...
We are at the end of an exceptionally long and strong global economic, equities, credit and property boom. The stress of the last 12 months has brought about the demise of many of the oldest and most venerable financial institutions both in the City and on Wall Street. Among the casualties were names such as Northern Rock, Bear Stearns, Freddie Mac, Fannie Mae and, most recently, HBOS, Bradford & Bingley, Merrill Lynch, AIG and Lehman Brothers. Despite the various coordinated government actions we've witnessed over the past few weeks, the stress in global money markets remains acute and the risk of significant financial aftershocks in the coming weeks/months remains significant.
Furthermore, the medium-term macroeconomic implications of the credit crisis are as yet unknown, and we would caution against underestimating the impact. In such an environment, as much as we continue to believe in the case for investing in the global emerging markets (GEM) asset class, the strength of economic fundamentals and the depth of its investor base, we do not see it decoupling or behaving any differently from previous global economic/market downturns, i.e. getting punished as the obvious 'risky asset class'. The massive outperformance of emerging markets over the course of the last five years and the large inflows they attracted from Western investors makes it a relatively easy decision for risk-averse global asset allocators to reduce their exposures, thus contributing to the sell-off.
As we write, things are looking bleak, particularly because markets haven't priced in a recession yet. It will get worse if and when statistics confirm that some of the major Western economies like the US and/or UK are 'technically' in recession. Emerging market equities have suffered a record $31bn of outflows so far in 2008 (versus record inflows of over $40bn last year). This has contributed to a near-40% dollar decline in GEMs year-to-date. This is worse than the MSCI World's 23% decline. It's the first time in years that GEMs have underperformed developed markets, and by quite a margin. Indeed, they are being 'punished', as usual, for being a riskier asset class, even though the sovereign balance sheets of Russia, China and most of the Middle East are far superior to those of the US or UK. Latest events continue to confirm that the real problems are in the West.
Several observers have been describing the ongoing global economic crisis as the worst since the Great Depression nearly 80 years ago. If they are right, then GEMs have another 10-20% downside before, we believe, very cheap valuations start underpinning a floor to what looks like a 'falling knife' on the charts. This would put this bear market's damage in line with the 50-60% damage suffered during the 1997/98 Asian/Russian crises and the 2000-2002 dotcom-related bear market. The question then is how long would it take for the dust to settle?
As if the economic gloom and doom isn't enough, we've witnessed a significant deterioration in the geopolitical outlook of places like Russia, Georgia, Ukraine, Pakistan, Thailand, Turkey, South Africa, Zimbabwe, Zambia and so on. It's too much negative newsflow at the same time, which doesn't help global investors' confidence in the asset class.
We strongly believe that current GEM fundamentals are nowhere near as bad as during the Russian and Asian crises. They are far stronger today. For example, it's difficult to imagine Russia defaulting today given its war chest of over $500bn in foreign exchange reserves (versus $60m when it defaulted in 1998) and oil prices at around $100 (versus less than $15 in 1998). The strength of GEM sovereign balance sheets could very well be used to 'support' their equity markets, and this seems to be something that a number of governments are currently contemplating. We have also started to see GEM corporates implementing share buybacks as they believe current valuations (in single digits) are too attractive. The average forward P/E ratio for GEMs is now at around 8x, which is at or near the lowest it has been in the past 20 years.
If someone wants to take a 'glass half full' view and not expect worse things to happen to the global economy and financial system in the near future, then the latest market meltdown has created a unique opportunity to generate exceptional returns from emerging markets. As to where the best opportunities are, we would rank Russia at the top of the list. This market hasn't ever been this cheap. It is now trading at 4x forward P/E, which reflects a 'distressed asset' situation. This could improve significantly if Obama wins the US elections, as we expect him to be more pragmatic and less confrontational than a Republican president regarding the Georgia issue, therefore leading to a reduction in Russia's currently exceptionally high risk premium.
Next is Brazil, where some of the best blue-chips, such as the world's largest iron ore producer CVRD (also known as Vale), are currently trading at forward P/Es of 7x. The country's vastly improved macroeconomic policies put most Western countries to shame.
We would also highlight the attractions of the Middle East. Indeed, they are a good reflection of the fact that emerging and frontier markets have come from economic obscurity to global relevance. The six Middle Eastern Gulf states of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE pump approximately 20% of global oil and have average daily oil revenues of around $1.5bn. They have plenty of petrodollars to recycle into their domestic economies and stockmarkets, given that their budgets are based on oil at around $50 per barrel. Valuations in these markets haven't been this attractive in a long time.
Russia, Brazil and the Middle East have one thing in common. They are resource-rich and are likely to be the prime beneficiaries from the ongoing commodities boom on the back of irreversible urbanisation, industrialisation and infrastructure spend in GEMs. The speculative froth may have been taken off commodity prices in recent months, but there are four billion people involved in this process, hence our high conviction in 'stronger for longer' commodity prices. This is not good news for China, which is short of commodities. However, China has a lot of other things going for it, not the least being cheap and abundant labour, making it the global manufacturing hub, and an extremely attractive outlook on the back of its sizeable, rapidly growing and affluent middle class. The Chinese market's valuation is now at its lowest in a decade and flirting with single digits, compared with 50x a year ago.
On the other hand, some emerging countries are still very vulnerable in the current market environment. These would include the Baltic countries, Turkey, Hungary and South Africa, all of which have been running sizeable current account deficits in recent years, which leaves them extremely vulnerable to currency shocks.
We also consider Mexico, Korea and Taiwan as less attractive at this stage, the former because of its high dependence on the US economy, which is facing a significant slowdown. The latter two are a concern because of their high export dependency as well as the fact that they are, like most Asian countries, short of commodities and will suffer further from sustained higher prices.
In the current market environment, fundamentals will continue to take a back seat. Newsflow is likely to be a key determinant of market sentiment in the short term, so we'd watch the Fed and other central banks closely and monitor their success in restoring confidence in the global financial system. Thus, technicals, sentiment and momentum are likely to remain the drivers of markets in the next few weeks and months.
- Slim Feriani is chief investment officer of Progressive Developing Markets.
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