July 29, 2016—Our Investment Committee (IC) decided this week to close the underweight to emerging markets (EM) equities we had initially adopted in 2013. Our clients have benefited from this underweight, as EM equities had generally underperformed broad international and global stock market indices. The IC has been monitoring the evolving EM improvement and focusing on two primary prerequisites that would need to be met before considering any trades:
- A Federal Reserve that is not likely to raise rates aggressively
- Indications that Chinese growth is stabilizing
Both of these conditions have been met, in our view. While concerns about China, the largest EM by equity market capitalization (number of shares multiplied by price per share) are still likely to flare up occasionally, the government appears to be successful in limiting downside risk, keeping any problems manageable. (For more on this, see June 2016’s Capital Perspectives “In Focus” article entitled, Tipping points for emerging markets)
Growing evidence on a number of other fronts supports the view that the tide has turned on EM and it no longer warrants a defensive posture. Year to date through July 27, the EM equity index (MSCI Emerging Markets) has outperformed the broader international equity index (MSCI All-Country World ex-U.S.) by 899 basis points, or bps (8.99%). EM equities are benefiting from favorable structural tailwinds, and diminished headwinds, which we expect will persist over our 9-12 month investment horizon.
Future Fed tightening is no longer a major headwind to EM equities
We believe that the headwind to EM equities from potential future rounds of Fed tightening has diminished. Our initial decision to underweight EM currencies came in the wake of the 2013 “taper tantrum,” which sparked capital flight from many EM countries, EM currency devaluations, and consequently, large EM equity losses in U.S. dollar terms. At the time of the taper tantrum, the Fed suggested that the potential adverse international impacts of Fed actions were of little to no importance in its decision making. However, the Fed’s view has evolved since its rate hike in December 2015. Today, we can take some comfort from the fact that the Fed has become more mindful of the international ramifications of its policy decisions, and is unlikely to take precipitous actions that can potentially be disruptive, particularly to EM stocks.
Chinese economic policy still faces challenges, but they are manageable
Chinese equities traded through H-shares in Hong Kong and through ADRs in the U.S. comprise about one-quarter of the MSCI EM index. We do not subscribe to ultra-bearish predictions of a catastrophic Chinese “Lehman moment” or “hard landing.” Nevertheless, we believe that economic policymaking in Beijing remains a headwind for Chinese stocks. Recent on-shore stock market interventions and managed currency depreciation suggest that economic policymaking suffers from intra-leadership quarrels, process opacity, inadequate communication, and poor execution. As a result, it is not unreasonable to expect additional negative surprises of an inadvertent nature. However, we believe the Chinese authorities ultimately have the resources and determination to manage challenges before they become full-fledged crises.
Global smart phone revolution is a structural tailwind for EM tech and telecom stocks
Technology and telecom stocks have been strong year-to-date contributors to EM equity index outperformance (Chart 1). Our 2016 Capital Markets Forecast (CMF) projects an intensifying long-term structural tailwind from such equities.
Expanding consumer demand for financial services is structural tailwind for EM stocks
The same can be said for consumer-oriented financial equities. It is notable that many of the equities making the largest contributions YTD are domiciled in Brazil. A solidly middle-income EM country, Brazil is a large market for consumer financial services. However, Brazil’s banks and other financial service providers have for several years faced strong headwinds from the country’s adverse political and economic situation. As these headwinds abate, the valuations of these stocks are likely to continue to abate.
Weak commodity prices are no longer a strong headwind for EM equities
The previously strong headwind from lower oil and metals prices is subsiding. Chart 3 shows the year-to-date contributions of energy and metals equities to EM outperformance. Our view is that crude oil prices are likely to further recover somewhat during the course of the next year, due to a combination of sustained Chinese energy demand and constricted U.S. supply.
Attraction of developed country bonds is a diminishing headwind
Investors who reside in EM typically allocate a portion of their portfolios to “safe” developed-country bonds denominated in non-EM currencies, even though these bonds have lower yields than local EM bonds. However, with developed-country bond yields falling into ultra-low or negative territory, the widening yield gap between EM bonds and developed-country bonds in 2015 and 2016 reduces the relative attractiveness of the latter. We are already seeing sizable net capital inflows into EM securities. Such inflows should help mitigate the general risk of major EM currency devaluations. Nevertheless, cross-border capital flows are fickle, and capital flight can occur very quickly. We believe even at ultra-low or negative yields, developed-country bonds will still provide a safe haven in the event a political or financial crisis impacts a particular EM country.
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