Emerging Markets: Down but not Out-VRK100-10Aug2013

Rama Krishna Vadlamudi, HYDERABAD       10 August 2013
www.ramakrishnavadlamudi.blogspot.com

Since the beginning of this calendar year 2013, emerging markets are down. Various reasons can be attributed to the steep decline. Predominantly, the perception of the US Federal Reserve tapering its bond buying program (QE 3) has rattled the world markets in the last two months. This has resulted in large outflow of money from emerging markets to developed markets. Of course, emerging economies have their own domestic problems, ranging from street protests, currency depreciation, large deficits, and steep fall in commodity prices. Global investors have started realigning their portfolios, moving from emerging markets to developed ones. The trend may continue for another few quarters, before investors flock back to emerging markets—which are currently down, but not out.

Comparing Equity Returns of Developed & Emerging Markets (2003-2012):

Notes: S&P 500 index represents US equities; MSCI EAFE - MSCI Europe, Australasia and the Far East index (excludes US and Canada); and MSCI EM - MSCI Emerging Markets index.

The MSCI EM index has outperformed both the S&P 500 and MSCI EAFE indices in eight out of ten years between 2003 and 2012. The equity returns are depicted in the above graph. Only in 2008 and 2011, the emerging markets equity returns underperformed both the US equities; and world equities (ex-US and Canada).

During the current calendar year 2013, the emerging markets have underperformed the US equities, as well as other developed markets. What is troublesome for market participants now is that the underperformance is very large. While the MSCI EM index has fallen by about 10 percent, the S&P 500 has surged by 18 percent, indicating an overall underperformance of about 28 percent for emerging markets in 2013 so far. This underperformance is due to fall, in the range of 10 to 20 percent, of equities in Brazil, Russia, China and India.

In Japan, the Prime Minister Shinzo Abe has vowed to double the country’s monetary base in two years—with Bank of Japan injecting massive doses of liquidity into the markets, in order to boost the crippled economy and tackle the entrenched deflation. Following this, the Japanese Yen has depreciated against the US dollar by 11 percent in 2013, while the Nikkei stock market index has shot up by 31 percent. Stock markets in the UK, Germany and France too have gone up this year.

What Caused this Underperformance of EMs in 2013?

In May this year, the US Federal Reserve had hinted at tapering of its bond buying program (QE3). It was perceived that the tapering would start in September this year and would end by the middle of 2014. The markets have taken this news of US Fed tapering very negatively. Even though attempts have been made to assuage the markets subsequently, the market perception has not changed. The US Fed, the IMF and the ECB have tried to calm the nerves of financial markets, by saying that they’ll try the easy money policies as long as their economies remain weak. The reality is that one day these central banks have to stop their massive liquidity injection programs, resulting in large money outflows from emerging to developed markets. 

With the hint of US Fed tapering, global investors have started selling securities, both equity and bond, in emerging markets and taking their funds back to the developed markets. The yield of 10-year US Treasury note has increased from 1.6% in May to the current 2.58%, attracting funds back to the US markets, in some sort of trend reversal.

(As part of its Quantitative Easing 3 or QE3 program, the US Fed is committed to buying bonds worth $85 billion per month. When central banks buy bonds, they inject liquidity into the banking system. The massive monetary stimulus from developed economies since the 2007/2008 Global Financial Crisis, particularly the US Fed, has resulted in enormous liquidity, said to be about $12 trillion, in the world fuelling price inflation in the emerging market equities/bonds and world commodities. This excess money has been circulating around the world, chasing returns and yields.)

Weakness in BRICS markets:

With the BRICs markets grossly underperforming the developed market indices, investors have started focusing on risks in emerging markets. In general, investors demand higher equity risk premium to invest in emerging market securities, due to higher risks in them as compared to developed markets. Even debt market returns in emerging markets are negative this year. Brazil and Turkey have faced massive street protests recently—impacting the investor sentiment negatively. (Interestingly, Turkey’s sovereign rating was upgraded to investment grade by Moody’s in May 2013).

India is facing its own problems. The Damocles sword of a rating downgrade by Standard & Poor’s is hanging on its head for quite some time. It is running a large current account deficit, in addition to high fiscal deficit and stubborn food inflation. In July 2013, Brazil increased its interest rates from 8% to 8.5% in response to growing inflation rate, while Turkish central bank intervened heavily and sold US dollars to prop up Turkish lira.

Chinese economy has slowed down in the past few years. The new Chinese government is worried about local government debt and trying to put restrictions on budget deficits and bank credits. Global commodity prices have corrected. Year-to-date, gold has corrected by 20 percent and silver by 34 percent approximately. Even copper, zinc and aluminum have corrected between 10 to 13 percent. Commodity-producing countries such as, Brazil and Russia, have suffered following the commodity price decline. However, crude oil prices have remained firm.

The commentary from experts indicates that the fancy for emerging market stocks and bonds has faded away for the time being, as the focus has shifted to developed markets and investors seem to have shifted their loyalty away from emerging markets.

Brazilian real, South African rand, Indian rupee, and Turkish lira have fallen anywhere between 8 to 12 percent since May this year, after the talk of US Fed tapering hit the markets. These currency depreciations have prompted selling in emerging markets.

Convergence between Emerging and Developed Markets:

Over the years, emerging markets have evolved with gradual opening up of their economies, achieving superior economic growths and creating a sense of political maturity. One interesting development in recent years is that it is difficult to distinguish between companies in the developed markets and emerging markets. For example, a large number of US and European multi-national companies (MNCs) derive their revenues from outside their countries, including those in the emerging market group. The US-based companies, IBM, Accenture, Coca Cola, and Pfizer generate more than 50 percent of their total revenues from non-US countries. So are Swiss-based Nestle and UK-based Unilever.

Even companies in the emerging countries have acquired a global status by acquiring companies in the developed world. India’s Tata Motors has acquired JLR, the Birlas have acquired Novelis, and Apollo Tyres is taking over US-based Cooper Tire and Rubber.

There was a time when different economies used to follow different monetary and fiscal policies. After the Global Financial Crisis, most of the developed economies have been following similar monetary policies—that is, buying bonds and injecting money into the financial markets. The US Fed, the ECB and the BoJ have followed these massive bond buying programs.

Convergence in the world markets has gone up. Correlations across equity markets have increased in recent years, especially in the last decade following increased globalization, massive surge in cheap money and interdependence of global trade.

Still Differences Exist:

While differences have narrowed down, there remain still a lot of differences between developed and emerging economies. Emerging markets still carry higher risks—ranging from volatile political/social environment, heavy dependence on commodities, weaker capital market regulation, higher market volatility, unsustainable current account deficits and currency risks. Global wealth is concentrated in developed countries.

Emerging Markets: Poised for Comeback:

At one end, global investors chase growth and/or yield. They’re quick to withdraw or invest their money at very short notice. But at the other end, large institutional investors, like pension funds, insurance companies and foundations, look for stable and long term returns. They lend stability to financial markets—be it equity or bond. They play an anchoring role in markets.

Emerging markets will continue to attract investor interest. Unilever increased its stake in Hindustan Unilever, its Indian subsidiary, from 52% to 68% by pumping in $3.2 billion. Diageo of the UK bought India’s United Spirits and UK-based BP invested in Reliance Industries’ gas blocks.

While emerging markets have not been doing well as compared to the developed ones at present, there exists a large potential for emerging markets to grow much faster than developed markets. Of course, there will be some rotation in the list of emerging markets. The focus of global investors will shift to newly emerging markets, where the prospects would be much better. The future of developed and emerging markets is interlinked. Higher fertility rates, advances in technology, education & healthcare, favorable demographic changes, and domestic consumption are still the star attractions for emerging markets. The negativity surrounding developing countries is justified, but no one can deny their potential for future and faster growth.

They’re down, but it’s not time to write them off.

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Notes:

BoJ – Bank of Japan

BRICs – A grouping of Brazil, Russia, India and China (sometimes South Africa is also included)

DMs – Developed Markets

ECB – European Central Bank

EMs – Emerging Markets

IMF – International Monetary Fund

Disclaimer: The author is an investment analyst and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors are advised to consult their financial adviser before making any investment decisions. The author’s articles on financial markets and Indian economy can be reached at:

http://ramakrishnavadlamudi.blogspot.in/