Will defensive attitude to emerging markets persist?
Emerging markets have managed a halting rally since the end of May as they took encouragement from the few positives that emerged from the latest euro summit, the falling oil price and a loosening of policy in China.
Nevertheless, they have continued to underperform developed markets, a trend that has been in place since October 2010. Back then it was reasonable to assume that emerging markets would underperform as they were trading at a historically high
premium to their developed counterparts as a multiple of their net tangible assets or book value. They were also having to combat rising inflation brought about by soaring commodity prices, a by-product of US quantitative easing. Furthermore, the problems in Europe were always likely to pressure the euro and lead to a rising dollar. Such conditions have, historically, been detrimental to emerging markets.
The situation now is more nuanced. Clearly the euro situation is no closer to a resolution, but the problems are certainly better understood and thus discounted in current equity prices to a much greater degree.
Emerging stockmarkets are priced at 1.5 times their book value – historically an attractive valuation. This is not far from the 1.3 times equity markets hit after both the 2008 financial crisis and the attack on the World Trade Centre in 2001.
Similarly, the current yield of 3.1 per cent has only been surpassed during the financial crisis and before that during the Asian crisis of 1997-98.
Inflation is much lower than it was 20 months ago, and although there have been some alarming short-term increases in certain food prices it has yet to impact rice, the key staple in so many countries. The oil price has also fallen sharply and there is a greater realisation that the supply-demand balance is nothing like as alarming as that promoted by oil bulls over the last decade. In fact, rising production in Brazil, Iraq, Canada and the US suggests that excess supply may be more of an issue than excess demand in the near future. This is very
positive for the vast majority of emerging markets.
The outlook for earnings in the developing world remains robust after the disappointment of 2011, when growth was non-existent. The squeeze on profit margins that resulted from rising inflation should not be repeated this year. Stockmarkets are currently priced at just nine times their earnings – a 20 per cent discount to developed markets.
However, one concern is the disparity in valuation between the defensive areas of the market and the more economically sensitive ones. This is now at a greater extreme than that seen in October 2011, after the sharp sell-off in August and September of that year.
In fact, this disparity is now even wider than it was in the dark days of 2008, when the financial crisis was at its height. Such extremes have proved to be good entry points into the market. Emerging markets rallied some 30 per cent in the six months following the lows of last October and, of course, far more after the lows in 2008.