Finding the cherries in Emerging Markets

Emerging equity markets have had a rough 12 months to the end of August, with the MSCI Emerging Markets index (price index) falling 27.2% in US dollar terms in the year, as the US dollar strengthened on better economic data from the US while commodities fell on weaker economic data from China. The weakness has been widespread, with emerging equities, bonds and currencies all falling, while only one MSCI EM country index is up over the period (Hungary, +6.6%) and none of the 10 MSCI EM sector indices are in positive territory.

Given the scale of some of the declines, a natural question for EM investors is when to rotate into the worst-performing parts of the asset class.

With the exception of Greece, the worst-performing parts of emerging markets have been in countries with either commodity exports or current account deficits (or both). These include Malaysia and Russia; Mexico, South Korea and Turkey; and Indonesia, Peru, Colombia and Brazil.

For the commodity-producing nations, irrespective of their current account status, the large falls in commodity prices represent a massive terms-of-trade decline that justifies the currency moves that have occurred. This decline in US dollar nominal GDP and in US dollar corporate revenues is unlikely to reverse until commodity prices recover, and the drivers of such a recovery cannot be readily seen in either supply or demand. We continue to see Russian equities as so cheap that a neutral position is justified, but we remain highly cautious on the other commodity markets.

The other three are more interesting. It has long been our view that Mexico, with its low level of credit penetration and strong economic linkage to the United States, is attractive from a top-down viewpoint. Whilst the political environment could be better, the main constraint to our investing in Mexico is valuations. Even with the decline in the market over the last twelve months, the MSCI Mexico index is priced at 21.1x expected 2015 earnings, which we continue to feel is an excessive valuation.

South Korea is a market where we have been overweight, viewing the export base of manufacturers and technology companies as well placed for a stronger US economy, as well as a government with policy options to support growth and an equity market that is attractively valued. Unlike our other three major overweight positions (India, China and Taiwan), all of which have outperformed, South Korean equities have not, as concerns about end demand in technology products and corporate governance have pulled the market lower. South Korean equities are extremely attractively valued, particularly some of the large exporters.

Turkey should have benefited from the collapse in commodity prices, but the equity market and the Turkish lira have been very weak. This partly reflects a significant deterioration in the political environment, with elections failing to produce a government at the same time as unrest in the Kurdish part of the country worsens. Additionally, and a particular concern of ours, Turkey has seen a major credit boom in recent years, significantly funded from abroad. From 2009 to 2014, private sector credit increased by 39% of GDP. This is second only to Thailand in our country universe, and this bringing forward of future demand will, we believe, act as a major constraint on future growth. The weak balance of payments also makes Turkey vulnerable to tighter US dollar liquidity. Although Turkish equities do now look cheap against their history, we cannot yet see the conditions to add to our positions there.