Stephen Cohen, iShares

Beyond taperophobia: Emerging markets revisited

Stephen Cohen, Head of Investment Strategy at iShares, looks at the future for emerging markets…

It’s been a tough year for emerging markets. Emerging equities have underperformed developed equities for the last two years, while EM debt has struggled during the Indian Summer. The outlook has recently begun to turn supported by the Fed’s “no-taper-just-yet” decision. Broad emerging market equities are also now at a significant value discount to developed equities. So where do emerging markets go from here? 

Recent liquidity challenges have reminded everyone that looking at the fundamentals of each country is important. Differentiating between countries is key and investors are taking a more nuanced approach.
We analyse emerging market economies based on their FX reserves and current accounts. A strong FX reserve and current account surplus suggests stronger support of the local currency and lower dependencies on external financing. Conversely, declining FX reserves and a current account deficit can prove toxic for emerging economies, especially in an environment of lacklustre growth and rising inflation. The recent performance in Indonesia, which has been hit by a combination of an unexpected inflation spike, substantial exposure to foreign investment and a rapid run down in FX reserves, is an example of this. The central bank there has attempted to protect the Rupiah by hiking rates by 1.5% within two months, however this is straining its already fragile economic growth. 
In the short term emerging markets are starting to see a cyclical upswing. They have been supported by growth in developed markets and the Fed’s current stance. Looking beyond that, structural challenges and risks such as a stronger US dollar and credit booms could yet spell trouble for emerging markets, especially those relying on external funding.
South Korea has attracted the most inflows of any single emerging market country so far this year. It has a current account surplus of 5.64% of GDP (as at Jun 2013 according to Bloomberg) which is amongst the highest in EM. South Korea has also benefited from its strong trade ties with the US and other emerging economies. Taiwan has strong trade links with the US technology industry and stands to benefit from the sector’s growth. It also has a very favourable current account surplus of 10.96% of GDP. 
Going towards the end of the year, we expect more clarity around the balance between reform and growth in China. This will come at the annual party plenum in Beijing, which is the first full year wrap for the new government. Investors are likely to position themselves favourably beforehand given data has recently improved. Given this, there is a tactical opportunity in Chinese equities, although long term reservations remain about the country’s transition to a different growth model.
Brazilian equities look attractive on a valuations basis. They trade at the lowest valuation ratio in Latin America, and are set to benefit from the recent pickup in Chinese data given Brazil’s export links to China.
In the near-term, local debt could outperform as EM currencies reverse some of their recent losses in the immediate aftermath of Fed-driven sentiment rally. Beyond that, external debt (IEMB) still looks better positioned within the EM space on risk-reward characteristics, given local rate and FX volatility.

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