The high levels of stock correlation that frustrated stock pickers last year have finally started to settle, and emerging market equities are leading the way, with the lowest levels of stock correlation in nearly a decade. Macro effects are on the rise in emerging markets, but there is still an opportunity for alpha generation from country selection strategies.
Macro risk is near term EM driver
“Macro risk, and in particular country risk, has been on the increase in EM. Lower correlation implies alpha opportunity at the stock level, but higher macro risk implies country selection as the key short term return driver in EM,” writes Citi analyst Chris Montagu.
Even though correlations are down, emerging market equity dispersion is still rather steady and low, which implies that stock selection strategies will have muted returns in the near term though they could open up over the course of the year. Finding companies with strong balance sheets operating in countries whose debt levels are under control (and whose currency is reasonably stable) gives a good chance for outperformance.
Montagu thinks there is a ‘binary split’ between emerging market countries with and without current account deficits, and that investors should give steer clear of deficits for now. There are concerns that tapering will hammer economies like the Philippines and India that have serious current account deficits which caused investors to pull their money out in droves when tapering was expected to start in September, and emerging market has seen similar outflows recently. Even if those fears are overblown it will be hard to earn decent returns when everyone else is fleeing the market you’re in.
Little consensus on Emerging Markets 2014 prospects
Some investors have argued that the most likely effects of tapering, such as FX headwinds, have already been priced into EM equities, and that the continued nervousness has left many stocks undervalued. Templeton Emerging Markets executive chairman Mark Mobius, for instance, has predicted emerging market outperformance this year, suggesting that anyone who gets in while the markets are still depressed could have a small windfall.
But the nervousness isn’t just confined to retail investors and market watchers. Brevan Howard shut down its EM fund earlier this month after losing 15% of its value in 2013 and another 1.6% this year with, in their estimation, not much chance of gaining that money back over the next year and no reason to take the chance because the fund is bullish on DM equities anyways.