What factors do we need for us to believe that EM assets have bottomed?
Capital has been exiting emerging markets (EM) over the last two years, driven by lower growth expectations and the prospect of higher interest rates in the US. All previous episodes of significant capital outflows led to a severe crisis (the Tequila crisis in 1994, Asian crisis in 1997, Russian crisis in 1998, Argentinian default in 2001, Brazil in 2003), but this time there has not been any major emerging market country even remotely close to default and sovereign external debt spreads have remained in a range since 2010. So why did EM become more resilient to external shocks? In the past, most EM currencies were pegged or tightly managed vs. the US dollar and EM relied heavily on short term external debt financing (the only source of financing available, making them extremely vulnerable to global risk aversion and capital outflows). In the last twenty years, local investors in EM (such as sovereign wealth funds, central banks, insurance companies, pension funds and private savings) have emerged, which progressively allowed countries to float their currencies and replace short term external funding with long term local sources of funding. This removed the currency mismatch between revenues in local currency and liabilities in US dollars. Another benefit of this evolution has been the ability for more EM countries to run pro-cyclical monetary policies. Previously, during a period of stress, they were forced to increase rates to extreme levels to defend their currency, slowing growth further at the worst possible time.
Two of our senior fund managers covering emerging markets, Simon Down and Raphael Marechal examine and assess the factors they believe need to be in place for capital outflows to turn around and for a sustainable recovery in emerging market assets to develop.
1. Growth Differentials
2015 can be summed up by one phrase, growth divergence, with the expectation that the US economy would be growing strongly whilst the growth outlook in other markets including the emerging world would be lacklustre. In 2016 there is more discussion of convergence with US growth proving weaker than expected and the US Federal Reserve also citing weak global growth as a reason for delaying their tightening cycle.
The IMF in its 2016 April outlook revised down its global growth forecast from 3.4% to 3.2%, which would be only marginally stronger than 2015. This marginal improvement is expected to come from emerging markets, though, with 2015 marking the end of divergence between emerging and developed market growth. From 2017 emerging markets are expected to once again start to grow at an increasingly rapid pace relative to developed markets, reversing a trend that has been in place for many years. 2015 is also expected to mark the bottom for emerging market exports and world trade. Meanwhile, PMI data also suggests that manufacturing is starting to converge between the emerging and developed world.
World Trade & EM Exports (%)
Markit Manufacturing PMI
Nikko AM Assessment: It would be much healthier for emerging markets if global growth was in a strong uptrend. So although emerging market growth should stabilise or even pick up relative to the developed world, the lack of positive momentum in the global economy remains an overall negative.
Fortunately, unemployment in the G3 has declined, which does justify the view that world growth could accelerate. For EM, most of the painful adjustment has been accomplished: real effective exchange rates have depreciated significantly, positive terms of trades have been restored, EM central bank reserves have stabilized and current accounts are improving rapidly. All the conditions are now in place for an export-led recovery of EMs. This will produce a much better “quality” growth than in the previous cycle (which was essentially fuelled by household consumption and credit).
We thus take a cautiously optimistic stance on this factor with EM now in prime position to benefit if global growth does improve.
China is important for two reasons, firstly its economic growth is critical to global growth given its significant size; and secondly, the potential for China to devalue its currency, which would then potentially lead to another round of competitive devaluations in EM.
Although in the medium term we expect China to slow naturally as its economy matures, in the short term, the economy appears to be gaining momentum, reacting positively to the stimulus measures introduced by the authorities in 2015. House prices and land prices have started to trend upwards once again, as has building activity and consumer credit. There has also been a clear acceleration in auto sales as consumers feel more confidence to buy big ticket items given government incentives announced last autumn. Despite downgrading its global growth forecast for 2016, the IMF just raised its forecast for China from 6.3% to 6.5%, reflecting these improving trends. Nominal GDP is also now accelerating, reaching 7.2% YoY in Q1 from 6.0% in Q4, with fears of deflation greatly dissipating.
Regarding the FX market, many investment forecasters still expect China to devalue its currency in 2016 by varying amounts, but the fears of a large one-off devaluation (or that the authorities could lose control of the currency) appear to be dissipating. A critical issue here is capital outflows, which have moderated in recent months. The authorities have tightened outbound capital controls whilst the data also suggests that repayments of US dollar debt was a key driver of these flows and that as the stock of debt has declined, the pressure for outflows should also decline naturally.
Caixin PMI Data
China Equity Markets
Nikko AM Assessment: Markets consistently overestimate the tail risk in China as they underestimate the level of control that the authorities can exert. The underlying economy in China appears to be improving now and this has caused some of these tail risk concerns to dissipate. The “local government debt for bond swap program” is being expanded with Finance Minister Lou Jiwei stating that the program will cover all of the local government debt funding for 2016. This will take pressure off of local governments, cleaning up the local debt overhang that has been a persistent issue for provinces in recent years. Premier Li is considering a $480bn infrastructure spend this year which should provide additional growth support. The problem of overcapacity in some sectors is still only moving gradually though. Overall we believe that the outlook for China has improved and should be at worst neutral for emerging markets as a whole through 2016.
3. Global Commodity Prices
Commodity prices have plunged in recent years as overinvestment at the top of the commodity cycle has resulted in oversupply in many markets. In oil markets, the technological breakthroughs seen in US shale oil extraction has also led to a re-evaluation of who is effectively the marginal producer and the long term equilibrium level of prices.
Although most commodity markets will remain oversupplied to varying degrees in 2016, the level of oversupply is being eroded by a combination of demand growth and a drop in investment. In a recent piece, we analysed the demand/supply outlook for oil markets and concluded that over the course of the year, the market would move from being oversupplied by around 2m b/d to only 600,000 b/d and potentially move into deficit in 2017.
Other commodity markets are following a similar pattern, although with some lag, and markets are now arguably looking through short term oversupply towards a more balanced market in 2017. Although this could mean that markets are in the process of bottoming, the fact that markets do remain oversupplied makes it difficult to ignore the chances of another dip in prices before a sustained move upwards.
US Shale Oil Production mb/d
Source: EIA / Bloomberg (March-May 2016 = EIA estimates)
OPEC Spare Capacity mb/d
Nikko AM Assessment: Commodity markets are certainly moving towards better conditions and we are more confident of the outlook in 2017. At this stage, though, there remain risks surrounding the outlook and this could still be a source of external shock for some emerging markets. Ultimately though, the asset class is very diverse, not all EM countries are on the same side of the “commodity trade” with some being exporters and others being importers. Although we believe that the outlook is improving it will affect different EM in different ways.
4. External Position
One problem that has faced emerging markets is the external vulnerability constructed during the period where the US was pursuing its QE policy. This has taken the form of sizeable current account deficits that built in certain countries and the related surge in corporate debt issuance in US dollars.
Firstly looking at current account positions, weaker growth in emerging markets, combined with currency devaluation has led to a sharp contraction in imports, boosting trade positions despite weak exports. This, combined with other factors such as a drop in outbound tourism and lower profits payable to foreign investors, has led to current accounts improving by some $140bn across the major emerging markets in recent years. This improvement is also against a backdrop of a collapse in commodity prices, so the value of exports has declined far more than volumes and, thus, any strength in commodity prices should lead to further improvement (although with some divergence between commodity exporters and commodity importers). Another positive factor is the US current account position. Although it has shown only a marginal increase in aggregate, this conceals a significant change in the makeup of the deficit. Oil imports have declined sharply as a result of shale oil production and lower global oil prices, whilst the non-oil deficit is now approaching historical highs in nominal terms.
Regarding external debts, there has been a seismic shift in government debt financing. The World Bank estimates that in 2000 about 55% of total outstanding EM government debt was in local currency terms, but by 2013 this had risen to 83%. EM corporates still rely on external debt (due to low US interest rates in US dollars), especially Chinese borrowers (although Brazil and others have large USD debts too, with Petrobras having the largest in the emerging world). Many companies have a natural hedge as they are commodity or goods exporters and receive US dollar revenues. Local banks are hedged and only exposed to a rise in NPLs if there is extreme currency devaluation which has limited the number affected. For example, in China a large devaluation of the Yuan would significantly increase NPLs in the financial sector and what would normally follow is panic, a run on banks and nationalization by the government. However, this scenario is highly improbable in China as banks are already tightly controlled by the authorities and the largest, most systematically important banks won’t be allowed to fail.
IMF Major EM Aggregate Current Account Deficit USD bn
Source: IMF / Bloomberg
US Current Account Deficit USD bn
Nikko AM Assessment: There has been a significant improvement in external vulnerabilities in emerging markets and 2016 should show a further improvement. One problem has been the decline in global trade, but we should now see an improvement in trade in 2016 as the worst of the commodity price decline is behind us and as developed market consumption continues to grow as labour markets tighten further. Remittance inflows have declined from their peaks, but remain substantial for some markets like Mexico and India, with a similar story for FDI.
Corporate debts have risen and this remains a cause for concern in EM. The Institute of International Finance (IIF) estimates that corporate debt in the top 19 EMs rose from 94.6% of GDP to 101.3% of GDP in 2015. Foreign currency borrowing has declined, though, with the Bank of International Settlements (BIS) estimating that a significant amount of Chinese capital outflows, for example, were actually used to repay US dollar corporate debts, with similar trends taking place across Asia in markets such as Thailand, the Philippines and Indonesia. Some of these moves will be driven by government policies, such as in Indonesia where the government has imposed restrictions on how much companies can borrow in foreign currencies relative to their total borrowing.
It would obviously be easier to declare that emerging markets assets have reached a bottom if valuations have become historically attractive, but breaking down the various asset classes gives quite a mixed view for this factor. In FX, there are pockets of extreme undervaluation, especially in some of the commodity exporters and in LATAM. But there are also some currencies that seem clearly overvalued, China being a prime example. In bond markets, nominal yields have risen, especially in the markets perceived to carry higher risks and this has led to historically attractive real yields being available in some markets. For equities, the gap between the P/E’s of the MSCI EM and World indices has widened and EM now trades at a sizeable discount. The ratio of the two markets has also declined to 0.50 from a peak of 0.90. These valuations have clearly improved but are still higher than the levels reached during the last emerging market bottom in the late 1990s.
EM vs DM Equity Markets
Source: MSCI / Bloomberg
JP Morgan REER EM Average (CPI Based)
Source: JP Morgan / Bloomberg
Nikko AM Assessment: There remains much value in EM assets after their declines in recent years. Although yields are lower than previous historical peaks, they are extremely high relative to developed markets considering that more than $5 trillion of developed market debt now trades at a negative yield. FX valuations show significant value in many commodity exporters and markets, with perceived higher political risks, but this undervaluation is not uniform in this segment.
6. Political Risk
Although cyclical vulnerabilities have been greatly reduced, there remain structural problems such as corruption, state-directed bank lending and excessive regulation. While money was pouring into EM assets as the US implemented its QE policy, the pressure was taken off EM policymakers and reforms in many countries ground to a halt. Pressure has built as global growth has stagnated and capital outflows have acted as a spot light on the weakest economies. Corruption and state intervention, which were overlooked, now undermine confidence and private investment. This has caused some markets, such as India and Indonesia, move to embrace greater reforms while others are still paying the price of previous complacency. Russia, for example, failed to diversify from oil and gas when prices were high, while in Brazil, the political noise surrounding impeachment and corruption probes have postponed important structural reforms.
Nikko AM Assessment: In aggregate, political risks in EM remain elevated, but some of the risks that had the greatest potential for unexpected outcomes have moderated. Ukraine is now a frozen conflict and Russian activity in Syria has declined. There is greater cross-market support across EM, which is also a positive development. China has provided loans for infrastructure spending globally and the Chinese-led Asian Infrastructure Investment Bank has entered into co-operative agreements with other major institutions such as the Asian Development Bank. This is an encouraging sign that the EM world is moving away from reliance on the developed world during periods of stress.
We continue to view political risk as being very important for individual markets and, thus, it is an important part of our investment process to understand the politics in each market. Many markets still have a lot of work to do on this front, but this factor should become more positive as the environment focuses political pressure.
Looking at the various factors it’s clear that there is a fundamental change occurring. The huge capital outflows of recent years (The Institute of International Finance (IIF) estimates that capital outflows reached $735bn in 2015, following an $111bn withdrawal in 2014) led to an underperformance in EM asset values. The currencies of markets with current account deficits have depreciated significantly as the deficits have become more difficult to finance. FX weakness and slower growth, or even recession in some major markets such as Brazil and Russia, has led to a drop in imports and this shrank current account deficits in the most vulnerable countries. At the same time, yields were forced upwards, as FX weakness fed into inflation, but real yields have now reached attractive levels especially when considering that inflation will likely decline as FX markets stabilise and allow interest rate cuts. This is especially the case relative to developed markets. There are now signs that the growth advantage is shifting back to EM and future growth should be healthier, driven by growing exports rather than consumer credit in coming years. Although global trade has been weak, this has been the result of the contraction in EM imports and also weak commodity prices, which have both directly affected export values and led to a drop in investment and, thus, capital goods orders. This negative cycle appears to now be in its final stages, if not already at an end.
Given this, we have become more optimistic about the outlook for EM assets over the rest of the year, and beyond, if global growth is able to gain greater traction. Political change will then determine whether some markets are able to achieve their full potential in the medium term. There is now a clear difference between those markets, such as India and Indonesia, who are implementing reforms and those who are still struggling to progress, such as Brazil and South Africa. The stress of the recent global environment is forcing change, as some domestic populations start to turn their backs on ruling political parties. Political pressure may now force those countries to attempt to catch up and make more radical changes. That would surely be a positive for the world.