The first quarter performance was mostly a reflection of amelioration of the global risks that had weighed on emerging market assets for most of 2011, specifically a response to the delayed impact of global economic data beating expectations for most of the second half of last year. It also reflected the lagged effect of the two long-term refinancing operations (LTROs) from the European Central Bank (ECB) which at the time appeared to take away much of the risk of a credit crunch in Europe’s banking system.
Ongoing global weakness
However, by mid-February global data had started to disappoint again and the spectre of a Chinese hard landing also reappeared, further dampening global sentiment and leading to a downward correction in commodity prices and emerging markets assets that are commodity dependent. As a result, the positive growth driver for markets disappeared but growth has not weakened enough to bolster market conviction that the Fed or the ECB were about to introduce additional quantitative easing or other extraordinary monetary measures.
Quite the contrary, statements from the Fed, the ECB and the Bank of England all suggested that developed world central banks were in wait-and-see mode. The result has left markets in a kind of no man’s land which first led to profit-taking on the Q1 rally and then a subsequent refocusing on a series of concerns, most notably the eurozone crisis.
A high degree of cross-correlation in many asset classes currently makes it difficult to diversify portfolios and under these circumstances it is unlikely that emerging market asset prices can decouple from global financial market moves, even if there is an element of economic decoupling in the way we expect. This was the experience during the global financial crisis and has also been the pattern this time around.
But such indiscriminate market moves also create long-term opportunities to get exposure in asset classes that sell off on heightened risk aversion not on the back of deterioration in underlying fundamentals.
Positive 12-month view
Growth in emerging economies is also slowing, although in cases like China and India a certain deceleration was necessary to bring inflation back under control and overall we believe that the sell-off has exposed long-term value in emerging markets assets, particularly equities and currencies. Markets like China and Russia look particularly attractive trading on forward earnings and price-to-book multiples that are at a significant discount to long-term averages.
Many emerging market currencies – for example the Indian rupee and the Brazilian real – have also sold off aggressively over this period and are looking better value, with some appearing relatively very cheap in relation to developed world currencies on measures of real purchasing power.
In the near term, emerging market asset prices are likely to continue to be held hostage by global events, particularly the current situation in the eurozone and continued doubt about the strength of the global recovery. But for investors that can look beyond this short-term volatility, we believe that valuations in emerging market equities and currencies represent a buying opportunity over a 12-month horizon.
History suggests that markets ultimately reward contrarians!
