Pimco’s El-Erian: Do not bet on a broad emerging market recovery

January 8, 2014 6:00 am

Do not bet on a broad emerging market recovery

By Mohamed El-Erian

Valuations are more attractive but stock picking is important

One striking aspect of last year’s markets is the extent to which emerging marketassets underperformed those in advanced economies. As investors search for returns this year among some frothy asset markets, such unusual underperformance attracts even greater attention.Emerging markets’ underperformance was broad-based, affecting virtually every asset class. EM equities underperformed the aggregate world index by a stunning 29 percentage points as measured by their MSCI index components. In external credit, the return on EM sovereign bonds was a notable 14 percentage points lower than that on high yield bonds (as measured by JPM EMBI Global and ML HY indices, respectively). Local currency EM bonds did even worse, returning minus 9 per cent according to the GBI EM index.

Some “classic” factors contributed to the disappointing performance of emerging markets. Top line revenue suffered on account of more muted growth and lower government stimulus, with related global demand uncertainties compounded by structural changes taking place in China. Profit margins also came under pressure due to inflexible cost structures.

Meanwhile, highly visible company debacles, such asOGX in Brazil, reignited concerns about corporate governance and legal protections; as did political instability in countries such as Turkey and Ukraine.

Financial engineering

Moreover, and again in contrast to their US counterparts, EM equities did not benefit from the financial engineering that many corporate treasurers pursued as a result of the interest rate policies adopted by G3 central banks. For example, aided by Federal Reserve policy, US company boards authorised as much as $750bn in share buybacks in 2013 (equivalent to almost 6 per cent of the capitalisation of the S&P 500 at the start of 2013).

As significant as these factors are, they do not fully explain the breadth and size of emerging market underperformance in 2013. Also, they are not enough to confidently anchor predictions for 2014. If they were, broad emerging market exposure would probably outperform this year, given the stabilisation in growth rates, higher export receipts, and declining Fed policy support for US corporate buybacks and dividend hikes.

To shed more light on what happened in 2013 and what is likely to occur in 2014, we need to look at three factors that many had assumed were relics of the “old EM”.

First, and after several years of large inflows, emerging markets suffered a dramatic dislocation in technical conditions in the second quarter of 2013.

The trigger was Fed talk of “tapering” the unconventional support the US central bank provides to markets. The resulting price and liquidity disruptions were amplified by structural weaknesses associated with a narrow EM dedicated investor base and skittish cross-over investors. Simply put, “tourist dollars” fleeing emerging markets could not be compensated for quickly enough by “locals”.

Policy makers stumble

Second, 2013 saw stumbles on the part of EM corporate leaders and policy makers. Perhaps overconfident due to all the talk of an emerging market age – itself encouraged by the extent to which the emerging world had economically and financially outperformed advanced countries after the 2008 global financial crisis – they underestimated exogenous technical shocks, overestimated their resilience, and under-delivered on the needed responses at both corporate and sovereign levels. Pending elections also damped enthusiasm for policy changes.

Finally, the extent of internal policy incoherence was accentuated by the currency depreciations caused by the sudden midyear reversal in cross-border capital flows. Companies scrambled to deal with their foreign exchange mismatches while central bank interest rate policies were torn between battling currency-induced inflation and countering declining economic growth.

Absent a major hiccup in the global economy – due, for example, to a policy mistake on the part of G3 central banks and/or a market accident as some asset prices are quite disconnected from fundamentals – the influence of these three factors is likely to diminish in 2014. This would alleviate pressure on emerging market assets at a time when their valuations have become more attractive on both a relative and absolute basis.

Yet the answer is not for investors to rush and position their portfolios for an emerging market recovery that is broad in scope and large in scale. Instead, they should differentiate by favouring companies commanding premium profitability and benefiting from healthy long-run consumer growth dynamics, residing in countries with strong balance sheets and a high degree of policy flexibility, and benefiting from a rising dedicated investor base.

Mohamed El-Erian is chief executive and co-chief investment officer of Pimco