Emerging markets have seen steady outflows since the economic data coming out of the U.S. and Europe started strengthening (and the Fed announced that tapering was on its way), but the argument that investors are shying away from EM market risk might be too simplistic. Comparing current valuations against what they were before the crisis, it’s clear that some emerging markets are faring much better than others, even with comparable earnings, and that risk is actually performing better than quality. According to Citi analysts Markus Rosgen and Yue Hin Pong, the real distinguishing factor is that investors are re-evaluating the emphasis they put on domestic demand.
Emerging Market (EM) blamed for account deficits
Current account deficits, which are bearing most of the blame for EM outflows, had been a good thing for both equity and bond investors. “For equity investors, excessive consumption over savings fueled the domestic consumption investment theme,” Rosgen explains. “For bond investors, it meant more bonds with higher yields.”
CA deficits weren’t nearly as important to investor strategy as domestic earnings and quality (cash flow and good balance sheets), both of which commanded a strong premium, and they don’t match up with consensus over/under-weights now. When Korea and the Philippines delivered similar levels of earnings, the Korean market fell 20 percent while the Philippines went up by more than 50 percent. Foreign investors believed that domestic earnings would be more resilient in the face of the ongoing global financial crisis, and companies with cash on hand were a better place to seek shelter from the storm.
Emerging Market stocks
Last month, despite all the news about funds unloading risk, EM stocks with high risk (high beta and volatility) were up 3.9 percent while good quality stocks (cash, balance sheets) were down 0.9 percent. “That’s a 4.8 percent point-spread in favor of risk when it would seem – according to the financial press – that the trade was one to get out of Dodge City EM,” says Rosgen. “Someone – those with money – are buying in to the idea of an improving global economy.”
Rosgen and Pong say they don’t have data in yet from all emerging markets (such as Latin America), but the initial picture is that people are moving away from one crowded, illiquid market to a cheaper, more liquid market that has more exposure to global markets. “As the patient recovers, so the current overweights which investors have in EM are in need of re-jigging.”