EM rally seen rolling on as valuations remain sound


Emerging market equities are up 21 per cent in dollar terms so far this year, while EM bonds and currencies have typically enjoyed rises of 6-8 per cent.

Since January, an unbroken run of monthly inbound portfolio flows have seen investors pour $140bn into developing world asset markets, building on the positive inflows seen for much of 2016, before the election of President Donald Trump prompted a two-month reversal, according to data from the Institute of International Finance, an industry body, as the first chart shows.

Given this backdrop, it is understandable that some are asking whether the good times can last or whether the EM rally is destined for a messy ending, even if some are exasperated by the question.

“We are five quarters into the emerging market rally and there are still a lot of naysayers. At every turn there are 1,000 reasons why it’s overdone or we are going to have a pullback or a collapse is coming,” says Bryan Carter, head of emerging market debt at BNP Paribas Asset Management.

“We think this is the real deal and will be a multiyear rally in emerging market assets. We see unequivocal evidence that investors are investing back into EMs and they are starting from a low base in terms of exposure to emerging markets,” Mr Carter adds.

While few are ruling out the possibility of a near-term correction, there are reasons to think the rally may have further to run.

George Iwanicki, emerging markets macro strategist at JPMorgan Asset Management, argues that neither valuation nor flow data should be a cause for concern.

Citing alternative figures from EPFR Global, a data provider, he notes that neither the inflows into EM equities or bonds since last year have so far been sufficient to make up for the outflows seen from those asset classes between 2013 and early 2016, as the second chart shows, suggesting there is scope for the inflows to continue.

As for valuations, he accepts they are not as cheap as they were with, for instance, the MSCI EM equity index now trading on a price-to-book ratio of 1.73, up from a low of 1.32 in February 2016, as the third chart shows. However, he says this is still below the long-run average of 1.8, suggesting little need to worry about valuations as yet.

Similarly, the cyclically adjusted price/earnings ratio, smoothing earnings over a 10-year period, is 16.1, well below the historical average of 24.2 and cheaper than developed world equities.

Ben Inker, head of asset allocation at GMO, a Boston-based asset manager, is another who is relaxed about the risks of a big sell-off. He argues that previous emerging market crises have generally been driven by “blow-ups” in either the currency or credit markets, neither of which he fears.

According to Mr Inker’s calculations, EM currencies were overvalued by at least 1.5 standard deviations, compared with their long-run average, before the sell-offs of 1997-98, 2008-09 and 2011-15. Today, however, despite rising from their lows of early 2016, they are still slightly undervalued, by 0.2 standard deviations.

Likewise, his analysis suggests that levels of credit in the emerging world are both declining and are around their historical norm, sitting comfortably below the levels that have presaged previous crises.

One caveat here is that credit levels in China are still at an “elevated level,” suggesting that the risk of contagion from that country is a “meaningful possibility”.

“The risk of broad contagion in emerging [markets] from a credit event in China is not horribly high, but we need to be aware of the risk,” Mr Inker says.

“An elevated credit cycle is by no means a guarantee of a credit crisis, but it certainly creates the conditions for a crisis to take hold. We believe a worst-case scenario is lower probability than normal, but by no means off the table.”

Mr Iwanicki also sees potential risks emanating from China. However, for him, the fear is that the removal of stimulus measures late last year means growth is likely to slow in the world’s second-largest economy, even as it ticks up elsewhere. Despite this, he remains confident China will avoid a hard landing.

Mr Iwanicki’s other perceived risk is simply one of complacency, encapsulated by the record low levels of volatility in financial markets. At this stage, however, he is “concerned, but not yet alarmed,” by hints of complacency, given that the volatility of the business cycle — as illustrated by measures such as the stability of earnings per share — has also declined, providing “fundamental support” to lower market volatility.

One other concern has to be any resurgence of dollar strength, which could potentially emerge if the tight US labour market finally starts to bleed into higher inflation, as economic theory suggests it should, prompting the Federal Reserve to raise interest rates faster than expected and pulling money away from the rest of the world.

Daniel Salter, head of emerging market equity strategy at Renaissance Capital, an emerging market-focused investment bank, notes that a rise in US inflation to about 3 per cent preceded the emerging market sell-offs of 1994, 1997, 2000, 2007 and 2011.

However, Jennifer Wu, a member of JPMorgan AM’s emerging and Asia Pacific equity team, argues that, globally, “inflation isn’t really forcing central banks to raise rates aggressively,” allowing the dollar’s erstwhile rally to peter out.

Mr Carter is even more relaxed about the possibility of any renewed dollar strength. He accepts that during the 20th century, a strong dollar often triggered an emerging market crisis, as in 1997-98.

However, he argues that this was because the economic cycle in emerging markets was not necessarily correlated with that in the US, as in 1997 when the Fed was tightening because the US was growing strongly, but Asia was not.

Mr Carter believes this has now changed: over the past 15 years or so the global cycle has become more correlated. As evidence, he cites the Fed’s 2004-07 tightening cycle, which coincided with strong emerging market growth.

“I’m shocked at how many people forget the last cycle. As long as the Fed is hiking for the right reason then rates hikes can occur coincident with strength in emerging market currencies, equities and debt,” Mr Carter says.

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