Portfolio managers had begun rekindling their romance with assets in emerging markets even before the European Central Bank unveiled monetary easing measures in early June. The policymakers’ moves — which include expanded long-term refinancing operations and negative interest rates on deposits to spur bank lending — really turned up the heat. Within days of the ECB’s announcement, the MSCI Emerging Markets Index shot above 1,055, its highest level in more than a year, as once-skittish investors demonstrated an eagerness to embrace risk in their quest for higher returns.
“Our research suggests that the world economy has emerged from the Great Recession, and on balance, today the global economic outlook remains positive,” observes Anthony Bor, who directs coverage of emerging Europe, the Middle East and Africa at Bank of America Merrill Lynch in London.
Pascal Moura, Deutsche Bank’s Dubai-based head of emerging-markets research, echoes that optimism. “In the U.S. the recovery looks firmly in place; Europe is not out of the woods but is making progress; growth forecasts have been revised to more realistic levels in emerging markets; and while many elections still lie ahead, the uncertainty around them has decreased,” he maintains. “Finally, the widely feared Ukrainian nightmare scenario now seems unlikely. In short, we expect volatility to stay low.”
As does Ronan Carr, emerging EMEA strategist at Morgan Stanley in London. “Following a first half that was littered with bad surprises — the Ukraine crisis, euro zone deflation scare, disappointing growth — we expect the second half to be less bumpy, with improving global growth,” he says.
But “less bumpy” doesn’t necessarily mean smooth. “Potential downside risks include tighter global funding conditions, should upside to bond yields and volatility materialize, and in China the property market correction may unfold more intensively than expected,” Carr adds.
“There is no doubt that market risks remain,” Bor concurs, “not least with new equity market highs being made these days in several regions, and question marks over the sustainability of the rates of improvement we have been seeing — in the euro zone and China, for example.”
As they travel down the road of economic recovery, asset managers will look to the sell side for help in steering clear of such potholes and speed traps, and they say no firm offers better direction than BofA Merrill, which leads Institutional Investor’s annual Emerging Europe, Middle East & Africa Research Team for a second year running. The bank’s analysts earn a spot in 20 of the survey’s 21 sectors, failing to appear only in Utilities, and fully three quarters of its teams are deemed the best in their respective coverage universes.
Deutsche Bank repeats in second place even though its total falls by two, to 15, while Morgan Stanley rises one rung to third after its total increases by two, to 11. Two firms share the fourth tier: J.P. Morgan, jumping from No. 7, and VTB Capital, which holds steady. Their team totals of ten reflect a gain of four for the former and one for the latter. Survey results are based on the opinions of more than 500 analysts and money managers at nearly 340 buy-side institutions that collectively manage an estimated $344 billion in emerging EMEA equities and $155 billion in emerging EMEA debt.
What prompted money managers to reconsider developing economies? “Investors’ positioning in emerging markets reached very low historical levels amid concerns for the sustainability of growth rates; the need for economic, social and other reforms; and vulnerability to tighter policy in the U.S.,” Bor explains. “Of course, the controversies over the timing of the latter issue in particular remain, but the growth outlook has become less of a concern, and with valuations in some markets having reached attractive levels, EM flows have begun to stabilize.”
Bor’s colleague David Hauner, who for a second consecutive year leads teams to the top spots in Economics and Fixed-Income Strategy, adds that seller’s remorse may be another factor. “We actually think that the outflows were exaggerated in the first place, as the public looks too much at a small data sample largely driven by retail,” the London-based economist explains. “Our more holistic data suggest continued inflows into emerging-markets debt in the past year, except during the peak of volatility.”
This bolsters his belief in a structural asset allocation argument for emerging markets. “[Group of Ten] investors are underinvested there when compared to the share of emerging markets in the global economy, and except when volatility is very high, investors want to continue to reallocate to EM,” he says. “There are cycles around this trend, driven by the growth differential between developed and emerging markets and by the strength of the dollar, but the trend is inflows into emerging markets.”
Investor interest, particularly with regard to bonds and currency, is likely to continue, he adds. “However, levels are getting stretched in yields and in foreign exchange, and at some point the U.S. Federal Reserve will have to turn more hawkish — which is the most likely trigger for a pickup in global volatility,” Hauner believes. “A gradual rise in U.S. rates does not need to be harmful for emerging markets as long as domestic fundamentals continue to improve. However, any major surprise from the Fed continues to hold the danger of a repeat of last year’s volatility.”
But that’s hardly likely, Deutsche’s Moura declares. “While we expect growth to bounce back in the current quarter and wage and price inflation to move higher, perhaps slightly faster than the Fed is projecting, it is unlikely that the Fed’s policy message will be changed meaningfully anytime soon — probably not until the autumn,” he says. “We see rate hikes commencing around mid-2015 and proceeding faster than the Fed currently projects. Rates moving higher will be a clear indication that the global recovery is on a firmer footing. Given where we are in terms of growth expectations in emerging markets, we expect that this should be a positive backdrop for EM equities generally.”
Exceptions will be economies with large current-account deficits, South Africa and Turkey being the two most prominent examples in emerging EMEA, he says. “Both of those countries had other problems to deal with at the time of the initial tapering move — protests, strikes, elections — and have now already seen considerable currency adjustment,” Moura points out. “We expect any further upward move in the U.S. bond yield to have less of an impact on those two markets’ relative performance.”
But problems remain. In South Africa some 80,000 miners have been on strike since January, with no resolution in sight, and the work stoppage is having a crippling effect on the nation’s economy. John Morris, who leads his BofA Merrill team to a second straight appearance at No. 1 for Southern/Sub-Saharan Africa Equity Strategy, says the strike prompted his crew to slash its forecast for South Africa’s real gross domestic product growth from 1.9 percent to 1.5 percent this year.
“Following the 0.6 percent decline in GDP in the first quarter, we see a slight 0.3 percent rise in the second,” the Johannesburg-based analyst says. “However, risks are skewed to the downside. We would not rule out a second consecutive negative quarterly GDP print, implying a risk that South Africa moves briefly into a technical recession.”
Once the miners’ strike is resolved, “output is likely to rebound strongly,” he adds, but that’s not the only challenge the economy is facing. “We expect a difficult year for households if our expectations for [repurchase agreement] rate increases prove correct,” Morris contends. “The credit cycle has yet to normalize from the 2008–’09 recession.”
From 2000 until 2008, he explains, South Africa’s economy grew by roughly 4.3 percent per year, on average, driven by commodities and credit upswings. According to his team’s analysis, however, its potential growth — the rate of economic expansion that can be maintained without triggering inflation — was 3.9 percent per annum during that period. Since then it has dropped a full percentage point, and more-rapid expansion is constrained by limitations in the country’s power supply. “To achieve a sustainable 3.5 percent GDP growth rate over the next five years, electricity consumption would need to rise a cumulative 25 percent in a timely fashion, and a delay in the timing of the planned electricity supply program is a risk to growth,” Morris insists.
Against this backdrop, his group is urging clients to favor banks over consumer stocks, which had been star performers in recent years. “The bid premium for the defensive qualities of retailers during the global financial crisis remains high, with food retail at 35 percent and general retail at 31 percent, compared to banks at only 8 percent,” Morris reports. “Banks have run hard recently. Tactically, we would be cautious in the short term, but we see further upside in the medium to long term.”
South Africa’s property market is also vulnerable, according to Athmane Benzerroug, who captains the Deutsche crew that extends its winning streak in Real Estate to a fourth consecutive year and co-leads, with Tomasz Krukowski, the No. 2 team in Construction & Engineering. “In 2013 we saw that the prospect of tapering in the U.S. created a high degree of currency and market volatility, particularly in emerging markets,” the Dubai-based analyst observes. “South Africa was one of the economies most impacted by this, due to its reliance on foreign capital to fund its large fiscal and current-account deficits.”
As the Fed continues to scale back its program of quantitative easing, U.S. bond yields will continue to rise and foreign flows into South Africa will continue to fall, he contends. “Because of the high correlation between bond and property yields and the continued upward pressure on bond yields, South African listed property is likely to perform poorly in the short term,” Benzerroug says.
The team is more upbeat about opportunities in the Persian Gulf region, where construction is booming. “The strong rebound in the Dubai market came from strong fundamentals, the attractiveness of Dubai and the return of investors’ confidence after residential prices crashed,” he explains. Although those prices have surged some 80 percent since their 2011 lows, he adds, they are still 35 percent off their peaks. Among the squad’s recommendations is Dubai-based Emaar Properties, which operates apartments, hotels and shopping centers throughout the United Arab Emirates.
BofA Merrill’s Ilze Roux, who directs the teams that rise from second place to finish on top for the first time in Construction & Engineering and Transportation, says microeconomics are a far greater driver in her industries than central bank initiatives. “Near term, the ECB actions suggest carry trades can persist for a while longer, but they are not viewed as a growth stimulator,” she maintains. “Globally, economic growth remains very modest. That leaves emerging markets’ growth still relatively more attractive than developed markets’, a reversal of expectations at the start of the year, but after recent strong market performance, we expect investors to be more balanced.”
She believes momentum is likely to be limited unless the ECB implements a program of quantitative easing, something that central bank president Mario Draghi says is possible. “At some point, bond and equity volatility will become increasingly vulnerable to events that question the assumption of the U.S.’s zero-interest-rate policy to infinity,” the Johannesburg-based team leader says. “The carry trade continues to support a stronger rather than weaker bias for emerging-markets currencies, but this has largely played out already.”
Carr, the Morgan Stanley strategist, notes that although the ECB has not implemented an asset-purchase scheme, its new policy initiatives “represent a step-change in monetary policy and should be viewed as a moderate positive. At the margin it should improve Europe’s growth outlook, benefiting linked economies such as Central and Eastern Europe, and add to liquidity globally, supportive for the likes of Turkey,” he explains.
“The success of the package hinges on the new targeted long-term refinancing operation,” adds Deutsche’s Moura. “Not all of the details are available yet, making a comprehensive assessment difficult, but at the very least it largely solves the three-year rollover challenge” now that an additional €400 billion ($541 billion) will be available for bank loans, he says. “Whether it genuinely incentivizes new lending is less clear. An [asset-backed securities] purchase program remains on the table. With or without QE, rates will remain low for some time,” he adds. “In the short term this is likely to have a more positive impact on countries with weak current accounts.”
That includes Turkey, with a deficit of roughly $5 billion. Opportunities abound there, according to Michael Harris, who guided BofA Merrill teams to victory not only in Turkey Equity Strategy but also in CEEMEA and Emerging-Europe Equity Strategy and co-led, with Stephen Pettyfer, the No. 1 team in Middle East & North Africa Equity Strategy before moving to Renaissance Capital in April to direct coverage of Turkey.
“On Turkish equities we are arguing that it is dangerous to be underweight with a backdrop of a global bid for emerging-market currencies and expectations that the central bank will further exploit this window of opportunity to loosen,” the London-based strategist says. “Even if loosening ultimately proves a policy mistake, raising beta positions in the market is unlikely to be punished near term, as it is doubtful Turkey’s currently rebalancing economy will reaccelerate enough to raise concerns until later in the year.”
Political risks are likely to remain muted ahead of a presidential contest in August, he adds, as candidates employ “conciliatory rhetoric” in the hope of winning at least 50 percent of the popular vote, the threshold needed to avoid a second-round ballot.
“This is a tactical rather than a structural overweight until Turkey takes its medicine and anchors inflation expectations and disincentivizes forex borrowing in the corporate sector,” Harris explains. “Our bias is for undervalued, out-of-favor stocks rather than more fully valued market proxies.”
His new colleagues Charles Robertson and Daniel Salter, London-based researchers who together pilot teams that capture second place in Southern/Sub-Saharan Africa Equity Strategy and earn runner-up positions in CEEMEA and Emerging-Europe Equity Strategy, emphasize that some of the biggest threats to emerging EMEA economies may not be so obvious anymore.
“The markets have gotten extremely confident that Spain and Greece would not consider leaving the euro to reduce 25 percent or more unemployment rates,” says Robertson. “Politics could easily surprise, as it did in the 1930s, when countries left the gold standard in similar circumstances.” A sharp uptick in U.S. inflation “is not priced in and would lead to significant emerging-markets currency weakness and intensified current-account financing worries,” he adds. Moreover, “there is also a high degree of complacency regarding the price of oil — from Russia to the Middle East, this is the most important variable of all,” Robertson believes.
“Equity markets assume tapering will continue until QE is completed sometime around the end of the year,” Salter reports. The question investors are asking now is, How sensitive is the U.S. economy to higher rates? If the answer is “very,” then a sharply higher Fed funds rate is unlikely, and that would be a positive for emerging markets, he says. But if a small upward move has a disproportionate impact, that could be more negative for developing economies. “It is the posttapering rates environment that looks likely to define which emerging markets perform best heading in to 2015,” he observes. • •
