Investors “Dumbing Down” in Emerging Markets

Terry Flanagan

Ashmore’s Jan Dehn said there is “serious dumbing down” with regards to emerging markets while Peter Marber at Loomis, Sayles & Company, said investors have thrown “the baby out with the bathwater” in the recent sell-off.

Dehn, head of research at Ashmore Investment Management, the UK-based emerging-markets specialist, said in a note that investors are overreacting to tapering from the Federal Reserve and have been too indiscriminate.

“Or put differently, there is some serious dumbing down going on in financial markets right now when it comes to emerging markets,” Dehan said. “EM debt levels (especially external debt), EM’s general reliance on external markets, and EM’s reserve holdings have all improved beyond all recognition over the past ten years. Also, the number of countries in JP Morgan’s EMBI GD index has more than doubled over the period, so the external debt asset class as a whole is today far more diversified than at any time in the past.”

Dean said all big generalised EM sell-offs have proven to be excellent buying opportunities. but warned that identifying value can be complex exercise. “Decide how much you want to buy. Divide your purchases into little bite sized pieces and begin to nibble. Keep your engagement active with a strong credit focus,” he added.

Marber, head of emerging markets at US fund manager Loomis, Sayles agreed that the fundamentals in emerging markets are much stronger than a decade or 15 years ago and that they are not as vulnerable as in the late 1990s. For example, emerging markets hold $7 trillion more in hard currency reserves to cushion themselves from market volatility than in 1998 and very few countries are near default.

Marber told Markets Media: “Investors have been indiscriminate and thrown the baby out with the bathwater as each emerging market has its own currency, economic rhythm and global trading pattern. For example, hard commodity exporters have been hit but we are bullish in 2014 on soft commodity exporters as food prices remain high.”

He said that emerging market stock multiples are very cheap with forward price-earnings ratios of between 10 and 11, compared to 16 for developed stocks. “However even if EPS growth looks pretty good, you have to wait and see that happens to the currency,” Marber added. “Investors believe that a lot of tailwinds that have helped emerging markets economies over the last decade have turned into headwinds.”

Loomis is recommending US dollar emerging market to defensive clients and remains positive on emerging Europe, which should benefit as Western Europe recovers.

“We are telling our clients to wait for the dust to settle,” Marber said. “We are in a similar position to 2002 where there are lots of elections in the biggest emerging countries and the market sees uncertainty with political risk becoming economic risk.”

Brazil, South Africa, Turkey and Indonesia are among the emerging markets with elections this year and Marber said few incumbent politicians are willing to implement painful reforms and risk re-election. “This week is a wake-up call for many emerging market governments: either implement needed reforms or face potential market attacks,” he added.

Dominic Wilson, chief markets economist of global investment research at Goldman Sachs Goldman Sachs, said in a report that spillovers from the sell-off in emerging markets into developed markets are likely to be short-lived.

“EM demand would have to slow sharply further to have a large impact through trade channels, particularly since lower commodity prices and bond yields would provide some offset,” Wilson said. “Transmission through financial linkages, either banking system or financial market contagion that tightens DM financial conditions, poses a higher risk. But DM banking exposures to key EM markets are not particularly alarming.”

Wilson cited BIS data stating that the total exposure of the developed market banking system to emerging markets is approximately $5tr, nearly 20% of overall external positions. However the the combined exposure to Brazil, Russia, South Africa, Turkey, Indonesia and India is estimated at $1.14tr, less than the combined exposure to Spain, Ireland, Portugal and Greece.

Wilson also warned that China plays an outsized role in many emerging market countries and so would be affected by a further sharp slowdown in China’s domestic demand.

Nikko Asset Management said in its latest Evolving Markets report that the impact of bad debts in China’s shadow banking system is likely to be more important to the global economy than Fed policy.

“Local governments have less capacity to offer rescues considering their own funding issues, and so we expect that many more defaults are likely this year,” said John F Vail, chief global strategist at Nikko AM’s Tokyo head office. “We have long been cautious on Chinese equities and despite low valuations, we continue to believe that corporate profit margins will be under pressure and that bank earnings understate the true problem of bad debts.”

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