There’s plenty of enthusiasm for emerging markets after the beating the sector endured last year. Such is the usual view of the world in January when investors look for fresh opportunities and there’s an army of strategists pumping out forecasts.
In terms of value, one key argument in favour of EM is that after several years of lagging performance, they now look a lot more attractive in terms of valuations, particularly versus the US. Helping matters is the fact that many EM currencies are cheap and a rebound versus the US dollar will help boost equities and bonds.
Tommy Garvey from GMO’s asset allocation team says looking through the lens of value shows that you can build a portfolio of high-quality EM companies with strong balance sheets that are cheaper than the broader MSCI EM index.
The rotation in value terms as shown here via GMO is between EM and US large-caps. The asset manager expects EM equities will deliver annual real returns over seven years of 4.7 per cent with emerging value stocks offering the highest return at 8.2 per cent.
Looking at macro forces, the question of timing the EM versus US rotation is tricky.
Plenty rides on China stimulating demand and the Federal Reserve pause in tightening becoming a full stop. EM bulls are looking for a lengthy Fed pause that caps strength in the US dollar.
Citi note that a softer dollar will help but also stress that “a Chinese economy that starts to recover from its 2017 de-leveraging cycle would undoubtedly provide a boon to EM and probably the export orientated Euro Area”.
In performance terms, EM shares have begun the year in fine fettle, but we are seeing signs of momentum slowing as they have climbed to a six-week high. The same applies to the JPMorgan EM currency index which has stalled of late, while the Bloomberg carry trade index is testing its high from last July.
UBS analysts for one think EM has rebounded a little too fast and write:
“Some of our top trades for 2019 in EM local bond markets like Brazil, India and China have already performed more than we had anticipated.”
Analysts at the bank are not convinced that the Fed will remain on hold and argue:
“Based on our belief that the US cycle is not ending anytime soon, we think the US front end and EM yields have rallied too far. EM carry has declined as hikes have been de-priced, leaving currencies vulnerable to the Fed coming back in play and a trade recession.”
As noted previously in Market Forces, the importance of China resonates for EM and among commodity producers such as Australia, Canada and Brazil. And the news here may not please markets that are leaning towards substantial stimulus from Beijing and placing their chips down on the table in favour of risk assets.
Dario Perkins at TS Lombard in his latest Macro Picture writes:
“The Chinese are gradually moving towards policy easing but are reluctant to introduce a stimulus on the scale of their previous credit splurges. We think they will stabilize their economy by midyear, but they won’t do enough to generate a powerful global revival.”
That’s not good news for countries like Australia and its currency — a barometer of China activity — as the FT’s Emma Dunkley writes here.
It also suggests that US equities loom as a better place for the moment than accumulating EM exposure. As seen here, EM equities performed better late last year, but now the S&P 500 is showing signs of picking up the pace.
Quick Hits — What’s on the markets radar
Netflix misses on revenues, beats on EPS — The streaming behemoth kicked off tech/media earnings on Thursday after the closing bell. In initial after-hours trading the stock was volatile, falling 5 per cent before recovering much of that slide. The share price has risen 50 per cent since Christmas Eve and among the Faangs, Netflix leads the way in terms of being closer to its 2018 share price peak.
The cheap pound — As the pound flirts with $1.30 for the first time since November, BCA Research make the point that the currency should be near $1.50 versus the dollar given that UK and US inflation and unemployment levels are close.
“It follows that the pound’s trajectory will be higher in any negotiated Brexit — or indeed ‘no Brexit’ — which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function.”
Easier said than done as we await the next twist in the Brexit saga.
Oil prices are looking toppy — The rebound for crude has been very robust of late but now the supply and demand picture entails a pullback.
The FT’s David Sheppard makes the point that being bullish on oil is the wrong call as much of the recent rebound has reflected shorts cleaning out their bearish bets. Now that the short squeeze has abated, oil looks set to head lower as the demand story remains bleak and there’s plenty of supply in the market. This will resonate as energy shares have set the pace of late in equities and in high-grade credit.
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