The investment house sets a cautionary note about emerging markets, contemplating whether the recent recovery presages anything more durable.
Emerging markets have enjoyed a strong performance this year, recovering somewhat from bloodletting of recent years, but there is not enough evidence to suggest that the rebound can be durable without underlying economic improvements, Schroders said in a note. In particular, the UK-listed wealth and investment firm said continued high reliance on commodity market earnings makes the EM sector fragile.
The firm examined different emerging market regions and concluded that a significant chunk of the rebound this year stems from Latin America. Within the region, Brazil’s equity market is by far the strongest performer (up around 15 per cent), with twice the returns of any other Latin American market, which are generally closer to the performance of Asia and EMEA than of Brazil. The MSCI Emerging Markets Index shows total returns (capital growth plus reinvested dividends) of 6.75 per cent from the start of this year through to 26 April (in dollars). Last year, that index slumped 18.61 per cent. The rise in the dollar, falls in global crude oil prices and fears about economic and financial fragility in China combined to hit most emerging market benchmarks.
In its note from Keith Wade, chief economist and strategist, Schroders said: “There will be some inflows to global emerging market indices in pursuit of the Brazil story, but that seems insufficient on its own. Trade is still soft. One of the key fundamental drivers of emerging market equity performance is export performance in US dollar terms. This matters because it impacts nominal dollar GDP growth, and hence the earnings potential in emerging markets.
“International investors are more interested in what dividends are available in hard currency, rather than local currency, and the equity indices are typically skewed towards exporters. The trend so far has been decidedly negative for the emerging market outlook. Trade volumes are expanding at a much slower pace today than historically, on a global basis. If this is a 'new normal’, emerging market trade values are unlikely to grow much faster than for the 2012-14 period. We would need global growth of over 6 per cent to see trade grow at its pre-crisis rate. The fundamental support for emerging market equities, then, looks weak. Trade looks to be structurally weaker and we do not see any immediate or even near-term catalysts for that to change. One short-term positive for emerging market assets should be the unwinding of commodity-related price effects on trade values,” Wade said.
“As these price effects unwind, nominal dollar earnings will be boosted which should aid equity performance in the short term. But ultimately we will return to the stale export growth profile of 2012-14, unless we see a serious boost to global growth,” he continued.
He argued that more than 70 per cent of equity market capitalisation in emerging markets is in net commodity importers, a fact that suggests most of the recent move in emerging markets looks to have been driven by sentiment alone, with the improvement in risk appetite coming at a time when aggregate emerging market valuations look attractive and investors have been waiting for an opportunity to re-enter the asset class.
“On this point, our view would be that the apparent cheapness in emerging market equities emanates from areas like commodities and Chinese financials, which all have potentially serious balance sheet issues, so the scope for rerating is limited. Arguably, anything you want to buy in EM already looks fair value, if not expensive. So, answering the question of whether you should be buying emerging markets right now, the answer is: only if you’re positive about the direction of risk appetite,” Wade said.