Tuesday, February 11, 2014

The Five Things That Have To Happen Before Emerging Markets Look Interesting

This year started off with emerging markets in the gutter. On the flip-side of that, the U.S. was expected to outperform.

Predictions are never perfect. Indonesia and Thailand markets have outperformed the S&P 500, even though the MSCI MSCI Emerging Markets is down over 6% this year. Then there's the forecast that the U.S. would start the year even stronger. Notes Jan Dehn, an analyst at Ashmore Group in the U.K.:U.S. manufacturing dropped sharply following two quarters of significant inventory accumulation. Non-farm payrolls disappointed for the second month in a row.

"If this run of bad data continues the markets will soon begin to ask why the Fed began to taper," Dehn said on Tuesday. Meanwhile, money is still flowing out of emerging markets, especially among the so-called "odd lot" investor. You know, the retailer who likes to buy at the top and sell at the bottom. They've been selling out off mutual funds dedicated to EM all year, according to EPFR Global in Cambridge, Mass.

Ashmore Group, a $70 billion asset manager in London specializing in emerging market bonds, outlines five conditions before investors return to emerging markets.

Ashmore Group, a $70 billion asset manager in London specializing in emerging market bonds, outlines five conditions before investors return to emerging markets.

"The real importance of these weak U.S numbers is that they help to restore rationality. The irrational selling of emerging markets over the past 10 months has only been equaled by the build-up of irrational exuberance about the US," says Dehn.

Now, perhaps, we can begin to hope for a return to rationality in both.

For emerging market investors, Dehn points out five signs though remains cautious in calling an actual turning point.

Five Signs EM is a Buy

1. The technical position in the market has to turn. This is largely achieved, though Ashmore does not rule out that outflows continue for a bit longer.

2. Fundamentals have to look okay. For the most part, emerging markets are expected to grow faster this year than last year. All eyes will be on China as the dragon in the living room for the time being. Declining PMI in services and manufacturing last month has investors thinking the No. 2 economy is going to grow less than expected. Fundamentals still part of the equation.

3. Better news has to flow from the "Fragile Five". These are South Africa, Turkey, India, Indonesia and Brazil, with Brazil and South Africa being the most iffy. All of these countries have raised rates, devalued their currencies, implemented fiscal adjustment where needed, and so on. None of these countries have a crisis per se, meaning unsustainable debts, running out of reserves, experiencing collapsing banking systems, or suffering wholesale corporate defaults. They face mainly macroeconomic disequilibrium and they are fixing these issues.

4. Valuations have to be attractive. With credit spreads twice pre-crisis levels for external debt and corporate debt and local currency bonds yields above 7%, Dehn thinks there is value and he is not alone. Bryan Carter, an emerging markets fund manager at Acadian in Boston, and Mauro Ratto, head of emerging markets at Pioneer across the pond in London both told FORBES last week that they agree. There's gold to be dug out of them thar hills, Yankee.

5. Opportunity cost. The loss of opportunity of not being invested in emerging has to become less attractive at some point. This also appears to be happening, judging by the latest U.S. data.

"We are not in the business of calling turning points," says Dehn. "The sensible way to approach the uncertainty
about timing is to decide on the allocation one wants to make to the trade and then chop it into a number of
bite sized pieces. This way one is sure to get invested when it is cheap, without risking shooting all of the
powder too early."

See: Fragile Five Is Latest Emerging Markets Club In Turmoil – The New York Times

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