The Bounce in Emerging Market Equities Won't Last Long

A sustained recovery has been underway in emerging market equities since February. As inflation falls and interest rates drop, self-reinforcing capital inflows are driving interest rates still lower, boosting growth expectations and increasing the attractiveness of the asset class.

The bounce could last 3-6 months…

How sustainable is the bounce? Our analysis suggests a further 3-6 month rebound is playable as liquidity conditions improve. But it is a counter-trend opportunity built on indifferent fundamentals. Valuations, while in line with norms are still well above those that prevailed on the eves of the bull markets in March of 2003 and 2009.  Although they might look slightly better relative to the U.S. than towards  the end of the Great Recession in 2009, it is only because U.S. equities are expensive. And, as yet, optimism on an accelerated pace of economic expansion in the developing world has not been vindicated.

Emerging market bourses are still vulnerable to a risk-off phase owing to political uncertainty, weak governance, and a lack of momentum behind the microeconomic reforms critical to ensuring a smooth transition to advanced country status. In fact, the current situation reminds us a lot of the temporary relief rally in 2012 following a diminution of euro zone tensions.

The chart immediately above shows that the MSCI Emerging Markets Index has underperformed over the past two decades, despite the rapidly expanding economies and Japan's dismal performance, which dragged down both the EAFE and Global benchmarks. The bourses did even worse in comparison with the US, returning on average a full percentage point less per annum, at just over 9% since the late 1980s. The numbers make still more depressing reading when risk is incorporated. Volatility in the emerging markets was 23%  and just 14% in the U.S., leaving the information ratio, or the return per unit of risk, at just over half of U.S. levels.

… and greater exchange flexibility has increased resilience…

Admittedly, past volatility is seldom an accurate guide to the future. Increased exchange rate flexibility has improved many countries resilience to capital outflows since 2012, compared with second half of the 1990s when they last suffered a capital drought. In isolation, however, the shift in exchange rate regimes is unlikely to compensate entirely for the political uncertainties, or for declining trend growth rates, as the economies mature and the U.S. consumer ceases to function as the buyer of last resort.

…. though political uncertainties are a medium-term drag.

Within the MSCI Emerging Market universe, five countries Brazil, Russia, India, China and South Africa (BRICS) account for nearly a half of the total market capitalization. In each case, the economies are the subject of political stress.

In China, the current leadership is consolidating its power base in the wake of President Xi’s four comprehensives. While none of the prongs of deepening reform, creating a prosperous society, governing the party strictly, or governing according to the law are particularly original, in combination they reflect a new cult of ideology. These policy objectives go hand in hand with the change in the leadership of the Politburo following the 18th Party Congress, which will guide the country for the next decade.

There are so many moving parts to the reform process that a policy mistake is almost inevitable. And the political temptation will likely be to shift attention away from internal problems via escalating regional conflicts with Japan and some of the SE Asian countries.

China has pursued a foreign policy based on “defensive realism” since the 13th century, focusing on its security. The best example of this was probably the short conflict with India in the early 1960s when it took back it's border posts while eschewing the option of more territorial acquisition. Even its contemporary policies in Africa are designed along the defensive realism model to ensure a steady supply of food and raw materials. And the recent rise in regional tensions gives the Chinese the same excuse to act “defensively” on their doorstep.

In South Africa, the “three finance ministers in a week fiasco” last year has been replaced by an uneasy calm. But the issues of corruption and growing grassroots support for the populist policies of Malema’s Economic Freedom Fighters  continue to stifle investment. At the same time, the ANC is losing support in the urban areas to the Democratic Alliance. The government is, therefore, hemmed in from both the left and right and is facing tensions within its ranks.

Russia, meanwhile, is still suffering from the economic sanctions imposed in the wake of the annexation of the Crimea and is increasingly ruled by presidential diktat, while the departure of the highly respected central bank Governor in India is a metaphor for the loss of momentum in Modi’s reform policies. Finally, in Brazil, the impeachment of the President is leading to a political gridlock at a time when there is pressing need to address the country’s poor productivity and rising indebtedness.

 Democracy alone is not enough…

Although Turkey has a much smaller market capitalization than the BRICS, the recent political problems are also worth mentioning because they are broadly representative of almost all the emerging markets. The attempted coup drew criticism from the advanced countries as undemocratic. Democracy, though, is not enough to ensure the efficient functioning of government, as the subsequent crackdown on the media, judiciary, and educational establishments highlights. The world abounds with elective dictatorships.

Respect for the constitution is critical. Honoring the rule of law, a separation of powers and the protection of fundamental liberties are all essential in a Liberal Democracy, notes Fareed Zakaria in his book “The Future of Freedom: Illiberal Democracy at Home and Abroad.” Turkey is an example of an Illiberal Democracy, and these types of political systems seldom produce an efficient allocation of resources.

More specifically, voluntary market and corporate governance mechanisms are usually weak when a country's governance system is wanting, argue Claseans and Yurtoglu in an article entitled " Corporate Governance in Emerging Markets: A Survey.” And when there is governance gap, competitiveness is adversely impacted, especially when corruption is rife.

Transparency International, for instance, examined the policies of 100 Emerging Market Multinationals recently, noting that 81 of them did not disclose a particular policy towards “facilitation payments.” The inevitable result is less access to funding and a higher cost of capital, which is perhaps one of the reasons  why emerging market equities have not been able to capitalize fully on fast economic growth.

…and political instability threatens supply side reform.

Political inertia and corruption also threaten the supply side reforms necessary to ensure that these countries can successfully negotiate the transition to advanced country status.   As economies mature, the easy gains in productivity from transferring labor from the rural to the urban areas are fading and growth is slowing.

 Total factor productivity is more important than labor productivity….

Too often productivity has been measured too narrowly in the emerging world. Labor productivity has been boosted by from the careless use of capital, incentivized by undervalued exchange rates and artificially low-interest rates, while total factor productivity has lagged. This led to the Asian crisis in 1997/8 as an unsustainable buildup in foreign debt to fund the investment splurge clashed with rigid exchange rates.

Nearly two decades later there may be greater currency flexibility, but the complexity policymakers face has increased dramatically. No longer does absorbing capital and imitating others guarantee success. The more advanced economies within the universe must now innovate in competition with the developed countries. And this, in turn, will require coordinated reform, across the labor and product markets, as well as the financial and trade sectors.

…. and countries that pursue supply-side reforms do better….

The IMF has demonstrated that emerging market countries, which have undergone large-scale structural change, have on average improved total factor productivity from -2% per annum in the five years before the changes to a small positive in the subsequent half a decade. Unfortunately, the momentum behind structural reform among developing countries has been painfully slow.

…. though the timing is critical.

Granted, timing is everything. When economies are weak reform can bring immediate economic pain. Reducing tariff barriers on imports, for example, frequently derails domestic competing industries, disrupting growth before the improved resource allocation has time to benefit the economy. This is not an excuse, though, to delay reforms indefinitely as some countries have done. Even India, regarded as a shining example of the benefits supply side reform can bring, has been dragging its feet. Markets are sill waiting for desperately needed changes in the energy, power, and mining sectors to eliminate supply bottlenecks.

Improved access to foreign funding threatens the reform initiatives…

There is a real danger that the new easier external funding conditions will take the pressure off policy makers in the developing world to implement unpopular reform processes that hurt vested interests. In which case, it might turn out to be a case of short-term gain for long-term pain. So while we can understand how liquidity fueled rallies can be self-fulfilling, just look at  the way in which the Turkish coup attempt was shrugged off, these economies have a structural frailty to any hint of risk-off conditions.

…and when liquidity dries up correlations rise steeply.

Inevitably, some readers will argue that viewing emerging markets in aggregate disguises their heterogeneity. We partially concur. There is a clear distinction to be made between commodity producers and consumers, on GDP per capita grounds, on the breadth and depth of their capital markets, and between countries funding their current account deficits with short-term capital inflows and the rest, to name a few.

But market correlations have trended steadily higher over the past few decades. And when market liquidity dries up during crises they have tended to climb especially steeply (chart above). This is not a time to be taking geared positions. The fundamentals just do not warrant it.