Emerging-market equities – potential for strong outperformance!

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Emerging-market equities have underperformed mature-market equities since the start of the year, with the MSCI Emerging Market Index down 1.4% while the MSCI World Index is up 2.04% and the S&P 500 4.6%. This raises the question of whether investors have lost faith in emerging-market equities.

Let us first look at the issue of valuation. In order to compare emerging-market equities and the S&P 500, I used two exchange-traded funds (ETFs), namely iShares MSCI Emerging Markets Index Fund (EEM) and iShares S&P 500 Index Fund (IVV). I calculated the annual trailing dividend yields on both since 2004 on a daily basis and compared them in the graph below. Please note that the prices I used were in fact the net asset values of the funds.

But why the dividend yield and not the price-to-earnings ratio, you may ask? Apart from a lack of information regarding the price-to-earnings ratio, I believe dividend yield is a better indication for investors in the ETFs as it is part of their actual returns. Furthermore, dividends are unaffected by accounting policy changes and adjustments that frequently occur and distort the earnings base of companies and indices.

Sources: iShares; Plexus Asset Management.

It is evident that the EEM has generally traded at a premium to the IVV since the EEM was launched, with the dividend yield significantly lower than that of the IVV. The major exception was from the third quarter of 2008 to mid-2009 during the global liquidity crisis sparked by the Lehman saga where the EEM actually traded at a discount to the IVV.

Why should the EEM trade at a premium to the IVV? The age-old investment adage of “relative earnings drive relative price”, and in this case “relative dividends drive relative price”, applies. The compounded growth in dividends of the EEM since 2004 has been 11.6% per annum while that of the IVV has been 1.5% per annum.

Sources: iShares; Plexus Asset Management.

The reason why the EEM moved from a premium rating to a discount to the IVV is evident in the graph below. The market expected dividends for the EEM in 2009 to be sliced significantly more than those of the IVV on the back of 2008/2009’s liquidity crisis. As the liquidity crisis eased because global trade normalised, the price of EEM relative to IVV reverted to the relative dividend index and thereby moved to trade at a premium rating to the IVV. Since the fourth quarter of last year the gap between the relative dividend and price indices has opened as more and more black swans entered the global pool. The gap surged at the end of the second quarter, though, after both the EEM and IVV went ex dividend in June.

Sources: iShares; Plexus Asset Management.

This resulted in the EEM trading on a par with IVV on a dividend yield basis.

Sources: iShares; Plexus Asset Management.

What this is telling me is that the EEM is currently priced in a similar way as in June 2008 just before the 2008/2009 liquidity crisis started in earnest.

Sources: iShares; Plexus Asset Management.

My reading is therefore that the EEM is priced for an imminent global financial disaster.

Sources: iShares; Plexus Asset Management.

I do not know whether such a disaster is indeed imminent, but I can play around with various scenarios, such as the Eurozone crumbling, the debt situation of local authorities in China catching up with them, another earthquake disaster in Japan, etc. But no one can tell.

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Emerging economies – short-term gain, longer-term pain?

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This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

Rather than signaling an extended period of tightening, China’s latest policy rate hike is expected to be the last of its kind in 2011. In a similar vein, policy headwinds to growth are set to ease in AXJ and LatAm, setting up the stage nicely for a rebound in risk sentiment. Even though most of the policy normalisation is ahead of us in the CEEMEA region, the overall change in sentiment should help here as well. Slowing EM growth will take some of the wind out of the sails of inflation and base effects will kick in over the next 3-4 months to push headline inflation lower, in our view. A macro environment where policy isn’t tightening further, inflation is on the decline and GDP growth is close to trend should be a potent combination for a recovery for risky assets. A final trigger for this change is the prospect for a better 2H in the US that our US team expects.

However, on a longer horizon, EM central banks don’t appear to have dealt with inflation conclusively. Risks to growth and particularly to inflation are to the upside. The ongoing inflation episode starred commodity prices while core inflation stayed benign almost everywhere. The next inflation story is likely to have core inflation in the driver’s seat. Central banks would then likely have to respond with another round of tightening. But this is a story for 2012, not 2011.

It should be noted that inflation in 2012 need not be of a rampant kind or even of a variety that central bankers will not be able to tame. Simply put, the return of EM inflation in 2012 is a risk, which implies that monetary policy tightening could also return. Until we get there, risky assets are likely to remain buoyant in the benign macro environment. In this note, we pay more attention to factors that could lead inflation higher, directing readers to our colleague Chetan Ahya’s note (Asia-Pacific Economics: Nearing the End of Rate Hike Cycle, June 30, 2011) for a detailed analysis surrounding the end of policy normalisation by AXJ central banks.

A Better Macro Environment Should Mean a Return to Risk

Inflation is set to fall in 2H11 in most of the EM economies we cover. We have argued in the past that moderate levels of inflation that most EM economies have at the moment are not a direct threat to economic growth. It is the actions of policy-makers who want to prevent inflation from rising that inflict damage on growth. If they didn’t act, inflation would likely rise to levels where it would directly hurt growth. To add insult to injury, policy-makers would have to then act even more aggressively to bring rampant inflation under control.

Oil and food inflation, which sparked the inflation scare, have been falling across the EM world. More importantly, growth is slowing to trend without a hard landing on the cards. Prima facie, there appears to be little reason for monetary policy to stay restrictive. And indeed, AXJ and LatAm central banks are close to completing the hikes they have in the pipeline for this episode. CEEMEA monetary policy was late to start rate hikes, given that the region’s economic growth lagged the other EM regions and most of the policy normalisation is therefore still ahead of us.

By that rationale, the fall in inflation – thanks in part to the growth slowdown – is likely to satisfy policy-makers and hence keep policy from getting tighter than it already is. Brazil’s monetary policy is the only one set to forge into outright restrictive territory and Turkey is likely to flirt with this boundary. However, in China and India – the other two economies where monetary policy is slightly restrictive – monetary policy is set to ease from its current slightly restrictive stance to a neutral one. In China, the policy stance could well ease over the summer and in India around six months down the line. This should set the stage nicely for a return to risk.

Caveat Emptor – The Second Coming of EMflation…in 2012

However, something will eventually have to give from the combination of falling inflation, economic growth at trend and policy rates on hold. Not just because it always does, but also because we argue that EM policy-makers, fully cognisant of the risks to US and global growth, have not been aggressive enough to put a more lasting dent in inflation. Our simple argument in this note is that, if these risks abate, and our economics teams expect them to, then the cyclical risks to EM growth and particularly to inflation are to the upside.

A familiar side-effect of better-quality global growth is higher commodity prices. However, unlike the 1H11 episode of EM inflation, it is not commodity shocks that are central to our argument here. Rather, it is that policy on hold and growth at trend render the EM world susceptible to upside risks, as we discuss below.

In addition to the cyclical arguments, structural drivers should keep inflation risks to the upside. Rather interestingly, the structural issues are set up such that EM inflation can rise even without an increase in the current level of EM growth.

Continue reading Emerging economies – short-term gain, longer-term pain?

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Managing emerging market risk, according to Pimco

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Masha Gordon, head of emerging market equities at Pimco, on how Pimco is managing tail risks in its EM equities portfolio. Despite current cyclical headwinds, Pimco sees a benign long term outlook, she says. However, she sees difficulties in investing in the Chinese market.

Click here or on the image below to watch the video.

Source: Financial Times, July 1, 2011.

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Mark Mobius on frontier markets

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A recent Q&A with Mark Mobius, Templeton Asset Management’s emerging markets guru, follows below, courtesy of the company’s monthly newsletter.

What are frontier markets?

Frontier markets are commonly used to describe a subset of emerging markets which have lower market capitalization and liquidity than the more developed emerging markets. More importantly they are markets that have not yet been “discovered” by the majority of investors. They are markets where there is limited research available to investors.

Frontier markets may generally be smaller and less developed than emerging markets, but they continue to experience strong economic growth and maintain a low debt-to-GDP ratio. They are where many emerging markets were 20 years ago. In the future, we expect these markets – at least some of them – to become quite important and to eventually become full-fledged emerging markets.

What is your rationale for investing in them and what’s the essence of your investment strategy?

Economic growth in many frontier market countries remains high and is even faster than some emerging markets and exceeds the growth in developed markets by a wide margin. The growth is not only economic growth but also growth in capital markets. Some of these markets are moving from small and illiquid status to large and liquid.

Many frontier countries are also leading producers of oil, gas and precious metals, and they are well positioned to benefit from the high global demand for these resources. Additionally, as the economies of frontier market countries expand, they continue to increase investments in infrastructure, offering valuable opportunities in the construction, transportation, banking and finance and telecommunications industries. Rising consumption provides these economies with strong purchasing power and the ability to spend their way into growth. Moreover, frontier market countries have been, and continue to be, positively impacted by the substantial investments made by large emerging market countries such as China, India, Russia and Brazil.

The economic drivers across frontier markets are diverse. For example, Botswana, one of the world’s largest diamond exporters, is introducing call and data processing centers. On the other hand, Kazakhstan, a country rich in oil and other natural resources, is seeing significant investments in infrastructure development. These varied economic themes across frontier markets ensure a diversified portfolio.

And why should investors care about frontier markets? Aren’t emerging markets already “risky” enough?

Frontier markets are actually not more risky than emerging markets or developed markets. Although there are a lot of uncertainties because of the general lack of knowledge among investors who don’t have the resources to study those markets, the actual risks are not significantly different from other markets. Although individual markets can be volatile, combined in a diversified portfolio they could be less volatile than a portfolio of developed market stocks.

How does the disaster in Japan (and potential slower growth from Japan), as well as the turmoil in Middle East, factor in one’s analysis of frontier markets?

The Japan and Middle East situations are not having any more impact on frontier markets than any other markets around the world. Of course, in the case of some of the Middle East markets there has been some volatility. However, the wide range of frontier markets going from places like Nigeria, to Vietnam and Ukraine means that events in, say, Egypt, will not have much impact on the other markets.

Continue reading Mark Mobius on frontier markets

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Are EMs the new DMs?

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This post is a guest contribution by  Manoj Pradhan of Morgan Stanley.

In today’s world economy, many old certainties have been swept aside. The adjectives ‘fragile’ and ‘robust’ have been switched between developed market (DM) economies and emerging market (EM) economies. Remarkably, the EM economies have contributed over 70% of global growth during the recent cyclical recovery and have done so without any hiccups from macro fundamentals or markets. Effectively, the title of this study is a question about whether EM economies can be the next long-term drivers of global growth and about the convergence of standards of living around the world. We examine this question from a high level of aggregation, splitting the world into DM and EM economies.

Is the EM-DM reversal of fortune really so stark, and is it durable? Depending on whether it is EM stock markets or European peripheral spreads soaring on the day, the phrases “EMs are the new DMs” or “DMs are the new EMs” can be heard quite commonly in the financial world. Though the latter phrase is used almost as dark humour, there is bright conviction about the former. We think that the broad structural story behind EM growth includes a variety of supports, many stronger now than in past decades – catch-up potential, favourable demographics, low debt burdens, sounder policies/institutions, better social capabilities and ‘self-insurance’ from sizeable FX reserves. But where exactly are the EM economies in their drive to become DMs?

Are EMs the New DMs?

Our short and simple answer to that question… is yes, but the transformation is not yet complete.

The longer and not-so-simple answer… In terms of growth, EMs have significantly outperformed DMs in almost every respect. Yet, EMs have yet to catch up in terms of levels. However, the fact that there is this gap between EM and DM economies also means there is scope for improvement, and therefore for sustained EM growth. There are risks to this convergence, however, from the DM and the EM side, which will likely take serious effort and considerable time to correct.

The Good, the Bad and the Ugly of the EM-DM Divide

We divide our analysis of the EM-DM divide into ‘narrow’ (one based on more or less standard macroeconomic metrics such as growth, inflation, debt, etc.) and ‘broad’ (based on socio-economic and political economy considerations) buckets. Our key conclusions on the EM-DM divide are as follows.

The (really) good… The quality of growth in EM economies has been staggeringly better of late. While DM economies have actually regressed, with lower and more volatile growth, EM growth has improved dramatically and on a steadier trend than in the past. In fact, macro-stability has improved in general. On the inflation, indebtedness and self-insurance fronts, for example, the success of EM economies has been remarkable.

More interestingly, and in our opinion more importantly as well, EM economies have narrowed the gap between themselves and DM economies on many of the ‘deep’ social indicators that are important for sustained growth. The deep determinants of longer-term growth such as life expectancy, schooling and economic and political freedom have improved in EM as well as DM economies, but by a much greater degree in the EM economies.

…the bad (well, not so good)… Even though the variability of GDP growth has not improved and the variability of inflation has continued to fall, in level terms, there is still clear daylight between EM and DM economies. A similar story exists for the deep parameters, like the political and economic freedoms and social indicators. But there is actually a silver lining here. With plenty of scope for improvement, the medium-term picture for EM growth remains well supported if reforms and investments continue.

…and the ugly: Despite all of the achievements we have outlined above, inequality in EM economies has actually worsened during a golden era of resilient development and income growth. Unless the rising tide eventually starts to lift most boats, there is a risk that a significant fraction of the EM world’s population ends up being excluded from the benefits of growth and convergence. As we know from history, such a trend could pose a political and economic threat to the case for a sustained structural EM advantage.

For the DM economies, the list of ‘ugly’ issues is much longer than it was half a decade ago. The risks to sustainable growth, a razor-thin margin for manoeuvre for policy-makers, adverse demography and high debt burdens mean that it may be the DM economies that pose the biggest threat to global and EM growth.

Mind the gap: Overall, EM economies have narrowed the gap between themselves and DM economies dramatically, but the emphasis on improving the quality of growth needs to be pressed further. Maintaining that pace may not be as easy or smooth going forward, but EM economies certainly have the momentum in their favour.

Continue reading Are EMs the new DMs?

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Emerging market equities: China to lead the way?

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Markit released the Flash HSBC China Manufacturing PMI for February based on 85% to 90% of responses this morning. The flash estimate came in at 51.5 compared to the final 54.5 in January as a result of a combination of seasonal factors as well as quantitative tightening. Wow, what a drop! That will surely be negative for equity markets and especially the Shanghai Composite Index? No, not necessarily. The manufacturing PMI reading per the official CFLP survey in January dropped from 53.9 in December to 52.9. Conversely, the HSBC survey’s January PMI picked up to 54.5 compared to December’s 54.4. According to the CFLP survey the drop in January was in line with the apparent seasonal trend in the past.

Sources: CFLP; Plexus Asset Management.

What do I expect for February’s CFLP manufacturing PMI? In previous articles I argued that the seasonal trend in January and February pointed to weakness, especially if the Chinese New Year and Golden Week fell in the early part of February. The timing of this year’s Golden Week was reminiscent of that of 2008. In 2008 the PMI in February picked up slightly from January’s but I suspect the number for February this year is likely to be unchanged to somewhat lower but not the significant drop as reported by the HSBC survey. My view that March could see a significant rebound continues to hold.

Sources: CFLP; Plexus Asset Management.

It is apparent to me that the markets do not really focus on the HSBC PMI survey but rather on the official CFLP survey. The Chinese equity market as measured by the Shanghai Composite Index is an excellent anticipator of the CFLP manufacturing PMI and leads the PMI by one month. It is telling me that the manufacturing PMI in February will come in unchanged or slightly improved. The surge in Chinese equities since the end of the Golden Week indicates to me that the market shares my optimism regarding the seasonal strength of the PMI in March.

Sources: I-Net; CFLP; Plexus Asset Management.

The bond market seems to share the optimism regarding the CFLP PMI in March and is looking through the current period of seasonal weakness.

Sources: I-Net; CFLP; Plexus Asset Management.

Is the Baltic Dry Index trying to tell us that China’s economy is stronger than generally thought?

Source: I-Net.

I guess so. It is no wonder the PBoC has again raised the reserve requirements of banks.

Are we therefore seeing a seasonal low in emerging-market equities? It is extremely difficult to anticipate the unfolding of the protest action in North Africa and the Middle East, though.

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