11 April 2014

Macro Strategy Update

Emerging Markets: Turn The Page

Executive Summary: We had been negative on emerging markets (EM) for quite a number of months now. The recovering US economy provides the Fed an opportunity to tighten monetary policy, which is generally negative for EM assets. This is coupled with a consensus underweight amongst investors since the end of 2013. However, the performance this year, especially after the Fed Chair suggested that rates may start rising as soon as 2015 is a surprising development. With improving current account balances and valuations approaching attractive levels, a shift in sentiment could swing investors back into favour with this region. We should adopt a contrarian view based on fundamentals and valuations and seek opportunities in EMs as it could potentially add value to one’s portfolio.

Portfolio Positions: In the shorter term, our view is unchanged. Given positive data points from developed economies, we still seek an overweight in portfolio positions in these countries. However, we will be preparing ahead, and seeking opportunities in EMs to add to our portfolios when growth characteristics and valuations become compelling.


In 1972, Bob Seger wrote “Turn the Page”, a song about the emotional ups and downs of life as a musician. We had been subject to similar emotional ups and downs from investing in EM after the amazing run from 2003 to late 2007. Emerging markets had all the attributes to perform well; a young and rapidly urbanising population, burgeoning middle class, increasing share of global consumption, large contribution to global GDP. Yet market performance since 2008 was hardly anything to shout about. With data pointing to an economic recovery in developed countries and an equity re-rating in these markets, it made perfect sense to increase our allocation there. On top of that, a tighter US monetary policy is generally negative for emerging markets assets. However, the time to turn the page on EM assets is coming soon. EM performance in 2014, and especially after the suggestion of a rate hike in 2015 has proved to be resilient. EM may be in for a period of outperformance as the market appears to have priced in the impact of tapering and valuations are reaching appealing levels.

Tapering Rout
After the serial underperformance since early 2013, we had been negative on EMs for quite a few months. The sell-off was made worse in the middle of the year after then-Fed Chair Bernanke first explored the possibility of reduced asset purchases (Fig 1).

Image courtesy of Stockcharts.com

Fig 1 – Rout in EM Assets in 2013

EM Challenges Remain
There are still many challenges for EMs to face, with estimated growth forecasts in a downtrend, real policy rates below the threshold for countries to finance current account deficits and a capital flight from EM stocks (Fig 2).

Fig 2 – EM Equities Hit by Strong Outflows Since mid-2013

Contrarian Performance.
The performance of EM assets since the Fed press conference in late Mar 14 has been contrarian. EM equities, bonds and currencies have been rising (Fig 3) even as investors are grappling with the prospect of rising rates. Broadly speaking, the EM asset class may have bottomed and we are seeing signs of stability even as US monetary policy changes. Valuations of many EM countries are also below long term averages and are approaching attractive levels (Fig 4).

Image courtesy of Stockcharts.com

Fig 3 – Rally in EM Assets

Fig 4 – Valuations of Most EM Countries Are Below Long Term Averages

Not So Fragile
The fragile five, a moniker coined by Morgan Stanley to describe Brazil, India, Indonesia, South Africa and Turkey, deemed to be most at risk to capital flight are no longer held captive by the threat of higher interest rates and capital outflows. Faced with high inflation, slowing growth and large current-account deficits, these countries underperformed in 2013. There have been steps towards reform and although risks remain, careful selection of better performing countries will reap rewards. The currencies and debt of Indonesia, Brazil, India and Turkey have been performing strongly in 2014 (Fig 5) even as short term Treasury yields have risen. We view these developments positively, as it suggests a shift in demand of EM assets. Once investors resume allocation to this region, we would see a meaningful outperformance versus developed market equities.

Fig 5 – The Underperformers Of 2013 Are Doing Better This Year

US Recovery
One of our views going into 2014 was that the US economy was set to improve. Weather related distortions affected data in Q1 2014, but now that we are into Q2, we can have a better sense of how things have been for the world’s largest economy. US industrial production continues to show a sustained growth in manufacturing. The data series measures real output, as opposed to sentiment driven surveys like PMI, so it gives a better indication of the health of the manufacturing sector (Fig 6). It is clear that the manufacturing sector continues to grow.

Fig 6 – Industrial Production Remains in an Uptrend

Leading and coincident economic indicators continue to show strength (Fig 6), and consumers are back after the spell of cold weather with the bounce in retail sales numbers in Mar, and a steady rise in personal consumption expenditure. This is no surprise as the economy continues to create jobs, while incomes have risen.

Fig 7 – Leading and Coincident Indicators Point to US Economy Strength

Rate Rise in 2015?
These developments are in-line with what the Fed has been expecting when tapering was first announced last December. With the improvement in the economy, it appears that the focus has shifted from tapering to normalising interest rate. Fed Chair Yellen suggested that Fed fund rates could start rising as early as six months after QE ends. US bond markets reacted accordingly by sending short term rates higher (Fig 7).

Image courtesy of Stockcharts.com

Fig 8 – Short Term Rates Rise While Long Term Rates Flatten

Some Warning Signs?
We continue to see deterioration in US and European equity markets with a deterioration of market internals while growth stocks lag the market. Coupled with the negative signals we see in consumer discretionary stocks (Fig 8) and now European financials (Fig 9), it is likely that both developed and emerging markets will correct as a wave of risk off trades takes place. That would produce an opportunity to increase our allocation in developed markets and possibly initiate a position in EM assets.

Image courtesy of Stockcharts.com

Fig 9 - Relative Underperformance of Consumer Discretionary Stocks

Image courtesy of Stockcharts.com

Fig 10 - European Financials No Longer Leading the Market


We had been negative on EM for quite some time now. EMs have also held up better than expected in the face of a change in US monetary policy. With improving current account balances amongst the weaker EM countries and equity valuations approaching attractive levels, a shift in sentiment could swing investors back into favour with this region. A developed market correction would spark a risk-off behaviour amongst investors and will allow us to increase our allocation in developed markets and turn the page on how we view EM assets.

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