In our most recent GMAG monthly blogs from April and May, we discussed how we position portfolios in sideways markets and the importance of being flexible to take advantage of tactical opportunities. In that vein, this blog is focused on the cyclical divergence between emerging and developed markets, and our increasing exposure to emerging markets.
While emerging markets remain in a delicate economic condition, several developments in the last few months have moved in the right direction, which, combined with available risk premia and valuations, increase the attractiveness of EM assets compared to the recent past.
Relative Business Cycles
While China continues to experience structural headwinds and lower trend growth, cyclical dynamics have recently improved, supported by renewed monetary and credit stimulus in the first quarter of this year. The first beneficiary of this policy support has been the property sector, followed by clear signs of stabilization in manufacturing. While there was some disappointment in the marketplace due to the most recent Purchasing Manager Index manufacturing headline numbers, the details in the survey point to a meaningful inventory destocking. In fact, inventories have registered the second lowest reading in the history of the survey (i.e., since 2004), nearly matching the inventory collapse experienced in Q1 2009. (Exhibit 1)
In our opinion, this backdrop meaningfully increases the likelihood of a rebound in production if final demand materializes in response to the credit stimulus we have seen. According to our business cycle framework, China has already entered a “recovery” regime where growth is below trend but accelerating (Exhibit 2).
This regime is typically supportive for commodity prices and emerging asset classes more broadly, given China’s dominance in global manufacturing (nearly 25%) and world commodity consumption (about 50% in base metals and coal, and about 15% in oil1).
On the other hand, our analysis indicates that most of the developed world is in a more advanced cyclical stage, entering what we call a “slowdown” regime, where growth is above trend but decelerating. This regime is typically characterized by mediocre returns for developed equities. This cyclical divergence is indicative of a relative value opportunity.
Equity and Currency Valuations
Relative to developed markets, emerging market equities are currently offering attractive valuations across several metrics, price to earnings, price to book, price to sales, and price to dividend yield. In fact, the price of EM equities are among the cheapest in the last 20 years and second only to the discounted values registered around the EM crises of 1998. In addition, many commodity-producing countries have experienced dramatic currency depreciations in the last five years, bringing long-term real FX valuations into cheap territory by 20%-30%, levels that have historically led to improving export performance and local equity market outperformance, both in currency hedged and unhedged terms. Today, Brazil, South Africa, Russia, Colombia, Mexico and others stand out as likely beneficiaries of cheap currency valuations, stabilization in commodity prices and a potential rebound in the Asian manufacturing cycle, led by China.
Risks to the View
The two biggest risks to our view are represented by China and the Federal Reserve. As discussed by our CIO, Krishna Memani in his recent blog, Chinese authorities have reiterated their view that the economy is entering a long L-shaped recovery, downplaying the optimism for a substantial rebound. Further, they have rightly stated that in the trade-off between slower growth and high leverage, slow growth is their preferred choice. In other words, the debt overhang (about 250% of GDP2) combined with an overcapacity problem, may prevent the current cyclical rebound from being sustainable. Under this scenario, the rest of emerging markets is likely to suffer as well.
Renewed hawkishness by the Federal Reserve would represent another risk to emerging markets. It would likely cause a replay of what we experienced in late 2015 and early 2016: a tightening in financial conditions via an appreciating dollar and widening credit spreads in highly levered debt markets. Given our cautious outlook for U.S. economic growth, this is not our baseline view, but certainly a risk to be considered.
It is too early to determine whether our re-rating of emerging markets will prove a short-term tactical trade or a long-term strategic holding in our portfolio. Emerging markets remain in a delicate balance between secular headwinds and cyclical tailwinds; this is what is creating an opportunity at the moment especially given attractive risk premia and valuations. If the cyclical tailwinds prove sustainable, then it will likely become a longer term strategic holding. However, there are several risks to our view, both within emerging markets and outside, which warrant a dynamic approach and a disciplined process to reassess information on a regular basis.
Visit our Global Multi-Asset Group webpage for additional insights about asset allocation and multi-asset investing.
1 Source: World Bureau of Metal Statistics, British Petroleum, as of 5/10/16.↩
2 Bank of International Settlements, as of 5/10/16.
The China Caixin Manufacturing Purchasing Manager Index tracks sentiment among purchasing managers at Chinese manufacturing, construction and/or services firms.↩
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.