Investors have quit emerging markets (EM) in droves in recent days following currency upheavals and a rethink on their growth prospects once central banks starting hiking interest rates to stem the rout.
“Many factors have been blamed for this latest burst of emerging market weakness – Fed tightening, rising political tensions, China credit concerns. But the most consistent concern seems to be current account deficits,” observe Citi’s Global Strategy Team in their recent research note ‘Avoid Big Deficits.’ “At times of rising market volatility, investors seek out safer assets such as cash or US treasuries. Those emerging market countries with the greatest external financing requirements have the most to lose as this fickle capital heads for the exit.”
Global selloff – is there a place to hide?
On a soothing note, the Citi team points out that investors have erred by painting all emerging market countries with the same black brush. In fact, taken as a whole, the emerging market countries have a surplus of 1.7% of GDP.
Therefore, investors should not move out of emerging market stocks just because of aggravated current account concerns in particular markets.
Separating the wheat from the chaff, Citi observes that equities in countries with large CA surpluses have outperformed deficit countries by a wide margin. By this thesis, investors might do well to invest in EM countries such as China, Korea and Taiwan, while avoiding Turkey, Brazil and South Africa.
Back-testing the thesis “buy surplus-sell deficit”
Citi decided to compare the performance of stocks in surplus countries with those of deficit countries via a long-short strategy.
“We ranked the world’s 35 largest equity markets by their current account surplus/deficit as a % of GDP at the start of each year. We then measure the average performance over the next 12 months of the top quintile (ie the 7 largest surplus countries) and the bottom quintile (ie the 7 largest deficit countries),” says Citi, describing its methodology.
This graph shows the strategy has produced positive cumulative returns on both dollar and local currency basis. It also outperformed the strategies of buying high GDP-growth countries and selling low GDP-growth countries, as well as another of cheap versus expensive countries, as measured by P/BV.
“Since 1995, the surplus country basket has outperformed the deficit country basket by average 10% per annum. If we strip out currency and just look at local equity market indices then the return falls to 5% per annum, but the progression looks similar,” observes Citi.
Can emerging market investors take a leaf out of the Eurozone’s book?
Citi points out that the above strategy, when applied to the Eurozone (EZ) countries, showed that it differentiated well during the three major sell-offs in 2010, 2011 and 2012, marked in the chart below in grey bars.
In particular, in the third bar, surplus countries outperformed deficit countries strongly, and therefore the strategy generated steep returns.
This showed that the markets rewarded those countries that were able to control their deficits and turn them around to surpluses. There is a lesson in that for emerging market investors, because history may repeat itself.
Engaging with the problem – Peripheral EZ versus EM Fragile Five
Given that it could be a while before deficit countries whose currencies weakened in the recent rout could convert this into an export advantage, Citi says that the first call of port on the road to stabilization of the current account would be an “import compression.”
Structural reforms, where India and Indonesia are ahead of emerging market peers could also accelerate the process.
The chart below compares the progress between the peripheral EZ and EM Fragile Five.
Note how the EZ peripheral countries have managed to convert deficits to surpluses. In contrast, the EM Fragile Five still have a long haul ahead.
Citi’s map below differentiates between emerging market countries that are cheap or expensive.
“We would favour those countries in the bottom right quadrant. These trade on lower P/BV ratios and enjoy current account surpluses. Alternatively, we would avoid those EM countries in top-left quadrant,” advises Citi.