Michael Santoli

Why investors aren't snapping up cheap, battered emerging markets

Michael Santoli
Emerging Markets Relief Boosts FTSE 100 From 5-week Lows
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Emerging Markets Relief Boosts FTSE 100 From 5-week Lows

It’s never easy to summon the nerve to buy while a market is selling off dramatically to the sound of scary news reports. The challenge gets even harder when you keep explaining to yourself why buying now is a bad idea.

This is what many investors and commentators seem to be doing as emerging-markets stocks take a beating. With the benchmark iShares MSCI Emerging Markets fund (EEM) sliding 7% in the past month – and the underlying stocks becoming as cheap relative to developed-market equities as they were in the 2008 washout – some would-be dip buyers are tempted but continue running through reasons not to step in.

As I wrote last week, it seemed the next dip in emerging markets would be a worthwhile buy for the stalwart investor looking to pick up exposure to the younger, faster-growing economies of the world for the next several years.

Is that promising “next dip” just about here? It’s unclear, as ever. Markets did trade more steadily overnight. And never forget: Authorities in the affected countries are not defenseless. The Indian central bank tightened monetary policy to buffer its currency, and in Turkey officials are expected to take a similar measure at an "emergency meeting" later Tuesday.

What’s striking, and at the margin encouraging, is that so many folks are explaining why not to be a hero by buying EM now. Here’s a critical look at the handful of reasons being offered:

“Sure, EM stocks are cheap - but they’re a value trap and will get even cheaper.”

There’s no doubt the earnings power of EM companies is at risk given the currency turmoil, continued weak commodity prices and local-economy consumer stress in some countries. Strategas Group points out that, on average, companies in developing countries have a lower return on equity, relative to their GDP growth rates, than those in mature economies.

Strategas’ Jason Trennert wrote to clients Monday: “One wonders whether the stocks of the companies in the most developed economies may be much better suited to enhancing shareholder value than those companies based in the emerging markets. One also needs to wonder whether stronger economic growth in the emerging economies is ‘diverting’ excess liquidity into the real economy and away from inflating financial assets.”

In other words, companies there aren’t managed as well and aren’t likely to navigate a slower, rougher economic path all that well.

Certainly, the risk that EM stocks are “cheap for a reason” is quite real; it was also present in 2008. Only in retrospect is cheapness determined to be a bargain or a trap. But it’s always better to buy when observable valuations are low, as they are now, than not.

“Sure, EM stocks are cheap, but outflows and technical pressure will continue working against them.”

As J.C. Parets of Eagle Bay Capital details here, the charts across EM are ugly, the very picture of sellers being in control. Mark Dow, a hedge-fund manager and blogger at Behavioral Macro, writes: “Now, the outflows come. Doesn’t matter what the trigger was. It’s on. It was just a matter of time. The path, the tricky part, will be fits and starts. Valuations won’t matter until we can tell a compelling growth story and too many EM countries have to work through all the domestic debt they built up during the boom.”

Emerging-markets mutual funds have seen outflows for 13 straight weeks, but the pace of withdrawals could pick up, as they’ve been less extreme than those seen last summer. The majority of equity inflows for more than a year have been in international funds, implying plenty of unseasoned money could exit.

This is why buying EM now should not be for a short-term trade but for the patient asset allocator to increase exposure in a measured way for the long term.

“Emerging markets were only floated by Fed easing, which is ending.”

It’s far from clear the Fed’s quantitative-easing asset buying was the only source of speculative flows into emerging-markets assets such as bonds and, by extension, stocks. But certainly it helped, and the perception that the “tapering” of QE means capital flows out of EM is powerful.

Michael Darda at MKM Partners says, “Premature Fed tightening could also be a drag on EM, but on this score we believe the concerns are overblown at this time.” Inflation expectations and broader financial conditions have remained stable, he points out.

It might be that emerging markets need to be “stress-tested” to see whether they can withstand continued reduced stimulus from the Fed, while China, Brazil and other countries defend their currencies with tighter money. 

“The emerging-markets as a single investment bloc is an obsolete concept.”

Maybe so. Joe Quinlan at U.S. Trust notes essentially half of world GDP now comes from countries categorized as “developing,” and today 32 countries count China as one of their top five export markets, up from two in 1990 and five in 2000. These markets have largely emerged.

It’s also common to hear investors ought to be selective within EM, avoiding the “Fragile Five” heavily reliant on outside capital – Brazil, India, Indonesia, Turkey and South Africa – and focusing on more self-sufficient, growth-attuned countries such as South Korea, Taiwan and Mexico. Jeff Kleintop of LPL Financial points out that the likes of the Philippines and Vietnam run capital surpluses.

For sure, a motivated investor with the time and acumen to select among individual markets could do better than the broad EM basket. Yet if the idea is to take advantage of big market dislocations to buy stuff cheap, the ultimate victory will come from adding to the most stressed markets – from some unknown, extreme price level.

“The real emerging markets now are in peripheral Europe.”

It’s true the ETFs tracking the most straitened EU members – the Global X FTSE Greek 20 (GREK), iShares MSCI Spain (EWP), iShares MSCI Italy (EWI) and iShares MSCI Ireland (EIRL) – have found new life. They've each risen betwen 18% and 35% over the past six months as the Continental economy stabilized and European Central Bank vows of ample liquidity measures were taken to heart.

Yet this is a fundamentally different proposition than playing the long-term demographics and development of emerging economies. It is, rather, a version of a consensus-surfing momentum trade.

"It’s all too complicated and difficult to predict.”

Yes, a vexing number of political, economic, currency and psychological forces are at work. From China’s efforts to bleed excesses from its overleveraged credit system to Brazil’s inflation-fighting efforts to the Turkish regime’s corruption scandal to Argentina’s ongoing gamesmanship with creditors, nothing about the EM rout is simple to handicap.

Keith Lerner, strategist at SunTrust, says he’s continuing to recommend underweighting of EM as he did to start the year. But the cheapening of the markets is making it, perhaps, a tougher call. “Relative valuations are near 2008 crisis levels; investor expectations are depressed and snapbacks after long periods of underperformance have often been sharp and difficult to time,” he grants. “We believe, though, that it is still too early to add to positions given ongoing currency concerns and political risks as several developing countries face important elections in 2014.”

It’s a sensible take. But will the opportunity be there to buy EM well, once all these uncertainties are neatly cleared up?

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