Value in emerging markets equities, but concentrated
Schroders’ Johanna Kyrklund, head of multi-asset investments, and Urs Duss, fund manager, multi-asset, give their views on emerging market equities…
Emerging market equities have had a difficult time over the last few months. In USD terms, the 12 month return to 31 March 2014 for the MSCI World index was 19.7 per cent compared to -1.1 per cent for the MSCI Emerging Markets index. As fund manager sentiment has turned extremely negative according to surveys such as the BAML Global Fund Manager, the question becomes whether this pessimism offers a good investment opportunity.
A cursory examination of current valuations would suggest that emerging market equities are inexpensive both relative to their own history and also US equities. Based on the historical relationship between valuation and subsequent 12 month returns, EM equities as a whole are approaching historically attractive levels and therefore could generate significant returns in 2014.
Upon closer scrutiny, however, it becomes apparent that there are particular themes that are dominating valuations. The majority of the value derives from investment and commodities, whilst on the other side of the spectrum, manufacturing and consumption are priced expensively relative to their history.
Within investment, the value really lies in Chinese financials whilst within commodities it is found within Russian energy stocks. Consequently a position in broad emerging markets based on valuation is, to a large extent, taking a view on these particular themes.
The current divergence in the fortunes of the BRIC countries highlights the need to consider emerging markets in more targeted fashion rather than as a single bloc. Russia is the most attractive based on value and fundamentals, but despite the recent sell-off remains dominated by the political risk premium. Brazil offers little reward in terms of either valuation or momentum with the continued downward earnings revisions. Elsewhere the signs are more encouraging from China and India. In the former the mini-cycles of stimulus and tightening offer tactical opportunities during the tricky road of re-balancing growth and deleveraging, whilst in the latter there is some momentum with the cheaper currency, improved current account deficit and anticipation of the election.
As a result, we consider that the current opportunity is greatest in Asian emerging markets. Thirty per cent of the MSCI EM Asia is from China, whilst another 44 per cent consists of Taiwan and Korea; countries we favour due to their robust fundamentals and participation in global growth.
The credit cycle – entering the stability phase?
After a very strong run through 2012 and 2013, returns are likely to be restricted to the carry available (the interest earned) in 2014. Although the consensus is that valuations are now looking stretched, the more challenging question is when should we be positioned more negatively towards corporates. It can be difficult, however, to predict the direction of spreads and indeed they have long been used as effective leading indicators within economic and trading models for other markets.
One way to approach this challenge is by analysing the credit cycle to try and establish what might trigger a correction in valuations. The credit cycle tracks the expansion and contraction of access to credit over time. A stylised version of the credit cycle can be divided into three parts. The downturn is the most painful phase for corporates as the recession hits activity and defaults increase, with the recovery phase characterised by balance sheet repair. This then prepares the way for the expansion phase of the cycle when there is increasing confidence and corporate lending resumes.
Credit spreads can help us understand where we are in the credit cycle. Phase 1 (the downturn) is when spreads are widening. To compensate, central banks cut rates as the economy is experiencing a slowdown or in recession. Phase 2 (repair/recovery) is when spreads are tightening as the economy moves out of recession and in to recovery mode. Phase 3 (expansion) is characterised by spread stability with investors benefiting from carry rather than capital appreciation.
US high yield debt is currently in phase 3 which is the expansion phase.
If we consider the credit cycle alongside the business cycle and the interest rate cycle, there are certain characteristics that we would normally expect to see prior to a deterioration in spreads. We would expect the business cycle to show signs of contraction and interest rates to be tightening. However, at present corporate balance sheets appear to be in good shape showing signs of recovery and interest rates have yet to rise.
Historically we have seen phase 3 of the cycle persist beyond the first rate rises and as a result we might conclude that we could expect two to three years of stable spreads. However, while this conclusion may be drawn from historical trends, there is no precedent for the current level of quantitative easing and ultra-low interest rates and as a result we remain cautiously positioned and watchful for any shift in investor sentiment triggered by a change in interest rate policy.
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