One region meeting this criterion is emerging markets stocks. We also expect inter-market correlations to fall, producing a potentially more fertile environment for stock selection. As such, we believe a more region-specific approach to EM stocks may bear fruit in 2013.
Having researched the three EM equity regions (Europe, Latin America and Asia), we believe that EM Asia offers the best risk-adjusted rewards for equity investors at present. EM Europe remains under pressure from structural challenges – continued deleveraging in the region by core European banks and high sensitivity to European growth.
While we feel that EM Latin American economies will be supported by firm real wage growth and good domestic consumption, the potential for rising inflation and relatively expensive current valuations dampen our enthusiasm for this region.
The economic and strategy reasons driving our preference for EM Asian equities are threefold.
First, EM Asian regional growth indicators are improving – China appears to have passed the bottom of its output cycle, with stronger export and industrial production data.
Taiwan has also seen better demand for its exports and consumer confidence is staging a recovery, notably in Thailand.
Second, local inflation should be moderate in 2013. Food prices, a key driver of local cost pressures, are benign in our view – the Commodity Research Bureau Foodstuffs Index is presently at its lowest level since December 2010 and 20% below its peaks that drove higher EM inflation in 2011.
Third, EM Asian consumption growth continues to blossom, not just in China but elsewhere too – Philippine consumption growth, for example, has run above the 5% rate for the past eight quarters.
EM Asian equity market characteristics are also supportive of investment, in our view.
First, valuations for the region are attractive, trading at a 10% discount to their seven-year average forward price/earnings ratio and a 16% discount on a price to book basis.
EM Asian equities also look undervalued compared to broader emerging markets and when compared to global equity markets.
A second support to EM Asian equities is better earnings prospects which we feel may drive local equity prices higher. Consensus forecasts for earnings growth are 16% in 2013, compared to 3.5% growth last year. Earnings revisions ratios (looking at the number of earnings upgrades versus downgrades) are strong in several EM Asian countries and have rebounded in others, according to BofA Merrill Lynch Asia Pacific Equity Research’s Nigel Tupper. Indeed, China’s revision ratio jumped in January to its highest level in two years.
Third, gradual appreciation of EM Asian foreign exchange against hard currencies (such as the dollar) is likely throughout 2013. In the most recent decade, EM Asian currencies have appreciated on average by 17.2% and we expect that this upward trend may continue as many economies relinquish control of exchange rates as a way of managing monetary policy or increasing export competitiveness.
Indeed, BofA Merrill Lynch’s Global Emerging Markets Research believe that, using a long-term equilibrium exchange rate model, EM Asian currencies are currently around 3.5% undervalued.
The 23rd consecutive week of inflows into EM equities and investor positioning considerations may justify short-term caution and targeted, opportunistic buying on dips. However, we believe that EM Asian equities should proffer both opportunities in 2013 and potentially beyond, given the importance of EM middle class consumption as a future global growth driver.
