The Bear Case for EM

Article source
The Economist

WHATEVER happened to emerging markets? They were supposed to bail the developed economies out of the financial crisis. And they were also supposed to provide an attractive home for growth-seeking international investors seeking to escape the moribund, ageing West. But over the past five years, despite the euro crisis, developed market equities have outperformed emerging markets by 41%.

Part of the reason is that, as Dimson, Marsh and Staunton of the London Business School have established, economic growth and equity market performance are not correlated. What may happen is that investors extrapolate from past economic growth and bid up equity markets to premium ratings, reducing future returns. But another problem is that stockmarkets do not exactly resemble the local economy, which may be dominated by family firms and government enterprises. China has produced plenty of economic growth in recent years, but the FTSE China 50 index peaked back in October 2007, at 30,711; it is currently 16,848.

More recently, there have been signs that the momentum of emerging market growth has slowed. As a contrarian, the temptation is to assume that this is a rather good time to buy. For a while this year, it looked like EMs were staging a comeback. But as of October 17, pretty much all of the early outperformance of EM stocks in 2014 had been eliminated. Over the previous 12 months (so dating back to October 2013), EM had underperfomed developed markets by 7.1%.

Given all this, it is worth contemplating an interesting summary of the bearish RM case from John Paul Smith at Ecstrat. At Deutsche, he was known as that rare, but honourable, character; the strategist who wasn't bullish on his own sector. He writes that:

"The shift towards more state-directed capitalism which has taken place across much of the emerging world since 2008, has undermined one of the key defining features of emerging markets as a distinct asset class, namely the gradual convergence of EM governance regimes towards so-called Anglo-Saxon norms. The term ‘emerging’ implies a dynamic, which is now no longer necessarily the case. Moreover, the growth differential between emerging and developed economies is also likely to continue to narrow, while a number of developed markets have experienced higher volatility than some of their EM peers over the past five years so the diversification argument for allocating to EM equities is no longer so valid.We believe that EM equities are only about two thirds of the way through their bear market relative to US equities in the current market cycle."

As Mr Smith points out, the worries can be seen most clearly in the BRICS (originally designated Brazil, Russia, India and China by Goldman Sachs but he throws in South Africa). Brazil's average growth rates in the last five years has been 2.7%; in 2004-08 it was 4.8%; Russia's average growth rate has slowed from 7.1% to 1.1% over the same period; South Africa's growth rate has slowed from 4.9% to 1.9%. India and China are performing better, but the trend is still down. According to Mr Smith,

"Consensus estimates of the sustainable rate of GDP growth of all five constituents of the BRICS have fallen by over 200bps (two percentage points)," adding that:

"The impact of slowing economic growth on equity returns through much of the EM universe has been compounded by the generally inadequate institutional and legal infrastructure to safeguard minority interests against those of the majority shareholders, in particular the state; Russia, Hungary and Brazil have so far been the worst offenders."

This rather undermines the best case for EM in that the equities are cheap; that won't help if shareholders cannot rely on getting their fair share of profits. EM shares should trade on a discount in such circumstances. As a recent column pointed out, the Russian attitude to minority investors means that its market trades on a trillion dollar discount.

Mr Smith argues that, when considering individual emerging markets,

"This time round investors need to look at the sensitivity to Chinese growth, the starting level of interest rates and bond yields (which is now generally much higher in the fragile five than at the start of the taper scare), the sensitivity to falling commodity prices including oil and the nature and extent of foreign financing, including the amount of net buying of equities over the past year."

A particular problem may be the strength of the dollar, which tends to suck liquidity out of such markets. Very few emerging markets will do well in these circumstances, he thinks, with the possible exceptions of Mexico, Poland and Turkey.

Whether or not he is right about the details, he is siurely right that the "blind faith" approach to EM (they are faster-growing, have younger populations, lower costs and fewer debts etc) now looks untenable.