As Emerging Markets push near one year highs, we wanted to refresh our core views on markets, outlook and risks. Emerging Markets equities (EEM, quote) have outperformed the SPX by 10% from the lows in March and an outright 5.5% in last 3 months. The outperformance has been diverse in country performance with rallies in all three regions with some outliers in the positive and negative camps.
In EMEA, Turkey (TUR, quote), Dubai and much of the middle East have soared. Russia (RSX, quote) and Poland (EPOL, quote) have been weak. In Latam, Brazil (EWZ, quote) has been a big mover on sentiment changes, while Mexico (EWW, quote) has lagged and is down 3% on the year. In Asia, while India (EPI, quote) is near all-time highs spurred on by the Modi election, Korea (EWY, quote) has struggled to rally and China (FXI, quote) continues to trade near the bottom of the standings.
The surprise of the Emerging Markets rally is that China has not led the rally as we might expect, but more importantly, it hasn’t hindered with extreme negative macro surprises. Meanwhile, the “Fragile Five” (South Africa, Turkey, India, Indonesia and Brazil) who were targeted for their current account weakness have been the best performers, not the worst as expected.
We take a view that the Emerging Markets equity rally will continue through the summer with a possible test of 1200 on the MXEF by the end of the 2014. The bullish call is rooted in a combination of technical and fundamental factors. Here is our snapshot of why:
- We see a reversion to the mean trade from a three year period where the MXEF underperformed the SPX after 45%
- Fund flow dynamics have changed with outflows of almost $50Bn over the last 18 months having reversed
- Fed tapering is ultimately positive for Emerging Markets equities are normalizing interest rates but more importantly expectation s of stimulus will firm up capital flow risks
Emerging market equities are not universally cheap after a solid bounce in most markets and an extraordinary bounce in a few.
- The MXEF is trading at 12.5x trailing earnings trailing, or in line with 5y and 10yr averages
- Brazil is expensive to 5y and 10yr
- Mexico, China, Russia, Korea Cheap
On China, we think the macro risks are overstated.
- PMI has been sideways for 2 yrs or more
- Citi negative macro surprise index indicated investors couldn’t really expect much less from China macro
As we look across the regions and the sectors here are the bullet points: ·
- Value will outperform growth. We see energy and telco sectors as offering the most upside on valuation
- Asia will continue to outperform
- Within Asia Korea offers the best combo of cyclical exposure and valuation: 9.8X ’14 8.6X ’15, with 20% EPS estimated growth in ‘14
- In Latam: Chile, which underperformed last 6 months, and Peru will be top 2H’14 plays as we see a combination of valuation and a recovery in miners. We see Chile (ECH, quote) with 20% EPS growth this year
What are the Risks? It's possible that too much hope for political and economic change has been priced in. Has India moved too far too fast, despite and improving current account? Turkey still has political opposition despite AKP victory in March.
Ukraine remains a trouble spot and tensions will stay high in the region. U.S. Dollar strength is always a concern for Emerging Markets. There is a 0.77 negative correlation of U.S. Index to Emerging Markets over the last 10yrs. Finally, inflation is still a risk in Emerging Markets and will remain the focus in places like Turkey, India and Brazil.