EM Exposure Affects Cyclicals And Defensives Differently

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Emerging market equities and European equities with EM exposure decoupled in 2011, with EM equities underperforming against the market and de-rating steadily, but in the last year the effect of different types of EM exposure have also diverged, pricing in a pessimistic view of EM growth that not everyone thinks is warranted.

“EM-exposed ‘cyclicals’ (broadly defined) are now starting to look attractive, with the Price/Book ratio at levels that have historically seen them outperform. They also look to be pricing in a sharp slowdown in emerging market growth, contrary to our economists’ expectations,” write Barclays analysts Dennis Jose, Ian Scott, and Joao Toniato.

EM equities have de-rated faster than EM exposure

Investing in stocks with EM exposure instead of EM markets themselves has become more popular recently, but the Barclay’s research shows that there is a big difference between cyclical and defensive exposure, with cyclical exposure outperforming during the 2003 – 2007 EM bull market and underperforming since 2010. Investors who want to increase their EM exposure through a European stock have to be careful about which type of exposure they are getting.

Of course EM equities and cyclicals with EM exposure don’t move in lockstep, and their performance started to diverge in 2011 as EM equities de-rated faster than cyclical stocks with EM exposure, but that trend has changed recently as both are now roughly following the same slope (though a gap still exists). This recent change is what gives investors an opportunity to bet against the EM bearishness without investing directly in EM stocks.

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Too early for defensives with EM-exposure

Jose, Scott, and Toniato argue that this EM pessimism runs against leading indicators, recent positive surprises in EM growth, and their in-house economists’ expectation of improving EM growth.

“We think that European cyclicals with EM exposure may now be starting to look attractive, and reiterate our Overweight on the Industrials and the Materials sector,” they write.

European defensives with EM exposure still carry a significant safety premium, so it’s probably a bad time to invest in them. If emerging markets rally then cyclical exposure should outperform, and if the EM bears are right then investors are probably better off just increasing their exposure to other markets.

“While this safety premium embedded within EM-defensives has certainly come down recently we think there is more to go, given our view that policy uncertainty in the EU declines further,” write Jose, Scott, and Toniato.

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