GEM valuations remain overweight SEI

Global stock markets, based on the MSCI AC World, declined approximately 4% in January [up 2.6% in February and down 0.6% so far in March] and emerging markets (EM) led the way down, falling more than 6%.

While watching these numbers drop is unsettling, none of this comes as a surprise: we have not seen such a correction in developed market stocks for a while but pullbacks are a normal and expected part of market movements.

 

Investors were extremely bullish at the end of last year and while that does not automatically mean a bear market is around the corner, it does indicate a certain vulnerability to negative surprises. 

 

The market may well be in a period where investors are resetting expectations, given heightened near-term volatility. In our view, however, the elements for a more serious equity bear market are not in place and the most important drivers of performance are still showing neutral-to-positive signals.

First up, global central banks, excluding the ECB, continue to support easy monetary policies, namely low interest rates and QE. Over the past few months, global bond markets have been preoccupied with tapering but we believe the Fed will keep short-term interest rates well anchored into 2015, if not beyond. 

 

The yield curve should therefore stay steeply upward sloping, which is the case for many fixed income sectors. Bear markets usually begin when a yield curve flattens and inverts, a sign of tight liquidity and impending economic recession. 

 

At the moment, any flattening in the curve reflects a risk-off move by investors, not a tightening by the central bank. 

 

 

 

In addition, we believe global economic growth is more likely to accelerate than decline. The IMF recently raised its forecast of global GDP growth to 3.7% in 2014, which compares favourably to 3% in 2013. Even emerging economies are expected to enjoy an acceleration of business activity, with GDP rising 5.1% versus 4.7% in 2013. 

Finally, despite robust gains across global markets, equity valuations remain reasonable.The US is among the more expensive markets in the world today, but even there price/earnings ratios and other metrics appear well within historical norms, especially against the backdrop of very low interest rates, still-expansionary monetary policy and further improvement in economic fundamentals.

 

In our portfolios, we moved overweight emerging market equities versus our long-term strategic weighting in the second half of 2013, as valuations appeared to reflect many of the problems plaguing these countries – namely poor economic fundamentals and concerns over both excessive debt and tapering.

 

Since we made this shift, volatility has continued in EM equities, running against our expectations that performance would stabilise due to the wide valuation gap.

 

For now, indiscriminate selling seems to be ruling the day – for EM bonds and currencies as well as stock markets – but we have maintained the overweight. Our logic is based on anticipating a rebound as governments raise rates to stem capital outflows and push through reforms to stabilise economies.

There are clearly many factors skewing investors’ view on emerging equities, including the ubiquitous impact of tapering, as well as China’s debt and widespread political uncertainty. But sentiment can often overshoot on the downside, leading to valuation anomalies and presenting opportunities for active managers. 

 

Merrill Lynch’s latest Fund Manager Survey shows a broad bias towards developed markets and away from developing, even though global growth expectations are close to previous highs in 2007. Investors are also ignoring the fact EMs continue to produce more positive economic surprises than developed.

 

We expect certain catalysts to improve the outlook, including an acceleration of global growth, a successful conclusion to the Transpacific Partnership (a trade agreement between the US, Canada, Australia, Japan and key Asian countries), easing debt problems in China, and economic reforms in some of the larger countries, including China, India and Brazil. 

 

With that in mind, we believe emerging equities remain positioned to perform well over the longer term. Economies in the region should continue to post faster growth as trade flows recover and also benefit from the expansion of an increasingly affluent middle class. 

 

As for EM debt, market pressures have driven spreads wider, to approximately 342 basis points (for dollar-denominated debt) from just over 300 basis points at the end of 2013. Despite the market movement, issuance has been strong and generally oversubscribed, despite reported retail outflows. 

We remain neutral on EMD given the shift in sentiment in recent weeks, which could create more downside risk despite fairly attractive valuations. 

 

Political and economic events have re-ignited concerns that could weigh on the asset class in the near term: the 2014 election calendar is busy in the emerging world, which has historically been associated with price gyrations. 

 

Overall, while there are risks to the global outlook, it is more a matter of growth staying sluggish than the world economy falling into another recession.