Too soon to buy unloved emerging markets; “Bottom-line, investors are now almost unanimously bearish on EM in their minds, but not so in their books. Contrarian investors looking for extreme distress ought not to announce a buying opportunity yet.”

Last updated: August 23, 2013 8:40 pm

Too soon to buy unloved emerging markets

By Robin Wigglesworth

To be utterly unloved is an unusual state of affairs for emerging markets.

Since the economic cataclysms of the 1990s, investors in developing countries have reaped a financial bonanza. But a combination of deteriorating economic fundamentals and the US Federal Reserve’s plans to “taper” its monetary stimulus has convulsed emerging markets since the start of May. Emerging market equity fund managers are more familiar with the unpopularity of their asset class than their bond colleagues. While the latter have suffered only a few dismal months, the former have been in the doldrums for a few years. But with sentiment so overwhelmingly bearish towards equities in particular, is this a golden contrarian buying opportunity?Not yet, is the cautious conclusion of asset managers and analysts. EM equities are cheap, but not exceptionally so, and are likely to become cheaper as investors reconcile themselves to the prospect of tighter US monetary policy, slower growth in emerging economies, and the risk – albeit faint – of a full-blown crisis in some countries.

“The question is why you would invest in emerging markets now,” says Michael Wang, a strategist at Amiya Capital, an emerging markets-focused hedge fund. “We have to ask whether the party is over.”

Despite a bounce on Friday, the FTSE Emerging Markets index has now slumped 11.6 per cent since early May, when investors began to fret about the impact of the Federal Reserve scaling back its monetary stimulus. But the drop comes after a long period of underperformance.

The FTSE Developed index of advanced economies is now only about 10 per cent below its 2007 peak, despite the body blows of the financial and eurozone crises. The emerging market index is almost 30 per cent below its 2007 peak.

This is in large part due to deteriorating economic and fiscal fundamentals. Citi’s economists downgraded their growth forecasts for emerging markets again this week, to 4.6 per cent this year and 5 per cent in 2014. But slowing growth is not the only sign of malaise.

Excluding China and the oil-rich Gulf states, the EM current account balance has deteriorated from a 2.3 per cent surplus in 2006 to a 0.8 per cent deficit this year – the biggest shortfall since 1998, Citi notes.

Some analysts say that emerging markets will inevitably be hurt if US quantitative easing is unwound – particularly those with deep current account deficits – but argue that the real headwind is these deteriorating fundamentals.

“If this was just temporary or dependent on economic policy, you would get a policy response from sovereigns and central banks. But it goes deeper than that,” says George Magnus, a senior adviser to UBS. “People are questioning the whole emerging-market story in the absence of structural changes. The tapering debate has simply exacerbated that.”

There are a few cautiously optimistic voices amid the bearish cacophony, however. Analysts at Bank of America point out that global fund managers are currently running their lowest EM equity exposure since November 2001. That could be a classic contrarian buy signal.

Robert Buckland, chief global equity strategist at Citi, argues the pervasive pessimism is now probably largely priced in. “Right now the in-your-face contrarian trade is to buy emerging-market equities,” he says. “But no one is quite brave enough for that yet.”

EM equities are now trading at a forward price-to-earnings ratio of about 10 times. Citi notes that this ratio is low enough to have predicted positive absolute returns across all major equity-market regions over the next 12 months 89 per cent of the time.

Nonetheless, even Mr Buckland has misgivings over some markets. He favours Asia over Latin America in particular. “We’re brave, but not that brave,” he says. “Overweight emerging markets is already fairly contrarian, and being brave squared is not something I want to do.”

The problem may be that many investors are already more overweight than they would like, despite the recent fund outflows.

EM bond and equity funds have registered net outflows of $20bn and $26.5bn respectively in the three months to August 21, according to Société Générale, but this is only a fraction of the money that has gushed into the developing world in recent years.

“Bottom-line, investors are now almost unanimously bearish on EM in their minds, but not so in their books,” Bhanu Baweja of UBS wrote in a note. “Contrarian investors looking for extreme distress ought not to announce a buying opportunity yet.”

History also offers some ill omens. Shifts in US monetary policy and a strengthening dollar tend to augur testing times for developing countries. Most are in far better shape today than during the 1990s, and few analysts expect serious crises. But the investor returns of the past are unlikely to be replicated.

“Emerging markets are facing a multiyear bear market,” Mr Wang predicts. “There’s a price for every asset, but I’m pretty sure we’re not at the right price yet. We’re still in the early chapters of what could be a long book.”