BlackRock-Emerging Markets-A Closer Look Market Perspectives-October2014

8/11/2019 BlackRock-Emerging Markets-A Closer Look Market Perspectives-October2014

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OCTOBER 2014

EMERGING MARKETS: A CLOSER LOOKWhere to Find Opportunities

MARKET PERSPECTIVES


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EXECUTIVE SUMMARY

RUSS KOESTERICH Managing Director,

BlackRock ChiefInvestment Strategist

This past spring we highlighted the argument for main-taining some exposure to emerging market (EM) equities(see Emerging Markets: Caution, Not Abstinence, April,Market Perspectives ). Since then EM stocks haveoutperformed their developed market counterparts.The asset class has benefited from stabilization in theChinese economy, market-friendly election results in Indiaand Indonesia and the growing perception that EM stocksare reasonably priced in a world with few bargains. The turnin fundamentals has also led to a turn in sentiment. EMequity flows have been positive for several months,

although EMs are still under-owned for the most part.

Even after the recent rally, we still believe that emergingmarkets represent a long-term opportunity, and thatinvestors still underweight should consider bringingtheir exposure back to at least a market weight.

That said, not all emerging markets are equal. EM Asia andparts of Latin America have rallied, but many markets inEMEA including Poland, Hungary and Russia continue tostruggle. For these reasons, along with material differencesin valuations, we believe that investors should continue tobe selective.

On a relative basis, emerging markets in Asia, includingChina, appear particularly attractive. After several years ofunderperforming, the region remains relatively inexpensive,despite the recent gains. In addition, most of EM Asia shouldalso benefit from relatively strong economic growth and lessexposure to reversals in capital flows.

[2 ] EMERGING MARKETS: A CLOSER LOOK


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BOUNCING BACKThe reports of my death have been greatly exaggerated.

Mark Twain

Earlier this year, emerging market equities were fast ap-proaching the status of pariah. After several years of under-performance, most investorsboth retail and institutional

were signicantly underweight, assuming they owned theasset class at all. Currency weakness and vulnerability tochanges in Fed policy, along with the prospect for a Chinesebanking crisis and/or economic hard landing, had succeededin driving what few optimists remained out of the asset class.Adding to the EM capitulation, 2013 was a stellar year foralmost every major developed market. For many investors,it made little sense to accept the risks inherent in emergingmarkets when U.S. small caps were posting 35% gains. Inshort, a signicant percentage of investors had abandonedthe asset class; this, of course, appears to have markedthe bottom.

Since then things have improved. Starting at the end ofMarch, which marked the low for many EM countries, EMstocks have actually outperformed developed markets byroughly 500 basis points (see Figure 1). Even after includingEMs disastrous start to the year, year-to-date, emergingmarket stocks are now outperforming developed markets.Similarly, weve seen a rebound in emerging market debt.

Several factors have contributed to the turnaround. Since thespring, most of the economic data out of China is consistentwith a soft landing, rather than the economic collapse thatmany had feared. EMs have also beneted from market-

friendly outcomes in two key emerging marketsIndia andIndonesiaand optimism for a third such outcome in Brazil.Many emerging markets have also made progress in reiningin large current account decits, a process that has allowedtheir central banks to adopt a more dovish stance.

In addition to the turn in fundamentalsor in many cases thehope for future improvementtwo other factors have contrib-uted to the turn in performance. First, investors are lessconcerned over the potential impact of higher U.S. rates.Defying virtually all expectations, U.S. long-term rates haveactually declined in 2014. While the Fed is likely to begin hikingshort-term rates in 2015, most investors expect this to be ameasured affair. Second, after frightening off investors in2013, many have re-evaluated the risks associated with amodest tightening of U.S. monetary conditions and concludedthat last years anxiety may have been overblown. After all,during the most recent rate hiking cycle (2004-2006), EM

FIGURE 1: MSCI EMERGING MARKETS VS.MSCI WORLD (2011 TO PRESENT)

Source: Bloomberg 8/15/14. Past performance does not guaranteefuture results.

R E L A T I V E P E R F O R M A N C E E M

V S

. D M

1/2011 1/2012 1/2013 1/2014

0.65

0.70

0.75

0.80

0.85

0.90

0.95

1.00

equities outperformed DMs. And even during last yearsso-called Taper Tantrum, volatility certainly increased for

emerging markets, but they held up better than many expect-ed. The added nancial exibility that oating exchange ratesoffer and the existence of a term structure of local rates allowEMs to facilitate macro adjustments when needed.

DISCOUNT RACKApart from some improvement in the fundamentals and afriendlier rate environment, another factor has been instru-mental in the EM turnaround: relative value. While most EMcountries trade well above the trough valuations of 1998 or2008, compared to developed markets these stocks are

reasonable and in a few cases cheap. That is as much areection of rising valuations in developed markets asdiscounts in emerging ones.

A signicant portion of the past two years equity gains inEurope and the United States has come from multipleexpansion. In other words, investors have been willing topay more for each dollar of earnings. In 2013 the price-to-earnings (P/E) ratio on the S&P 500 rose by approximately22%. This was the single largest increase in valuations since1998. More recently, European valuations have climbed fromthe bargain levels seen in 2012 and early 2013. As a result,the trailing P/E multiple on the MSCI World Index of developedstocks has risen by more than 20%from around 14.5x tonearly 18x earningssince the summer of 2012. Japanstands out as the exception, a large developed market thathas not witnessed signicant multiple expansion over thepast year.

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tions. Recent data conrm that while China is looking atgrowth in the 7% range, it does not appear to be on the

precipice of a more violent deceleration (see Figure 3).

MAYBE THE GLASS IS HALF FULL?The combination of all of the above factors has contributed toa notable change in investor sentiment. While most indicatorsstill suggest that few are overweight emerging markets, therampant pessimism of 2013 and early 2014 seems to haveabated. Sentiment is still a long way from the extremebullishness of late 2010when emerging markets brieytraded at a premium to developed marketsbut perceptionsof emerging markets do appear much more balanced than

was the case even six months ago (see Figure 4).

At the same time, EM valuations have remained relativelystable and are still below their long-term average. Despite

EMs outperformance year-to-date, at 11.2x forward earn-ings, EM valuations are still considerably cheaper thanthose of most developed markets (see Figure 2).

FALSE POSITIVEThere is no getting around the fact that the outlook for Chinaexerts an outsized inuence on investor sentiment. True, theoutlook for emerging markets extends well beyond China,and much of the recent optimism over EMs, and even morespecically within Asia, can be traced to post-electionoptimism in India and Indonesia. But given its economic size

and geopolitical signicance, China has a disproportionateimpact on investor perceptions of emerging markets. Achange in expectations regarding China will, for betteror worse, affect the rest of EM Asia.

This is why concerns over Chinas banks and declining growthrate are responsible for a signicant portion of the pessimismdirected at emerging markets over the last couple of years.That is why the recent stabilization in the Chinese economicdata comes as a welcome relief; steady data in China arehelping to counteract fears that a slowdown would morphinto a crash.

To be clear, there is no doubt that the Chinese economyis slowing. Nor are there many investors left who expectChinese growth to reaccelerate to the torrid pace of 2010. Ifnothing else, the decline in the Chinese workforce will makegrowth at those levels all but impossible. Still, the PandaBears who forecast a Chinese hard landing were not correct.China is slowing, but the slowdown appears measured and inline with ofcial targets and more realistic investor expecta-

FIGURE 4: FUND MANAGERS SAYING THEY AREOVERWEIGHT EMERGING MARKETS

Source: Bank of America Merrill Lynch.

( % )

200920082005 2006 2007 20112010 2012 2013 2014

FMs Net % Say OW GEM Equities GEM Performance vs. World

-40

-20

0

20

40

60 140

130

120

110

100

90

80

70

60

FIGURE 3: CHINESE NEW ORDERS INDEX(2010 TO PRESENT)

Source: Bloomberg 8/15/14.

C H I N A P M I N E W

O R D E R S

1/2010 1/2011 1/2012 1/2013 1/2014

47

49

51

53

55

57

59

61

FIGURE 2: RELATIVE VALUATION EMERGING VS.DEVELOPED MARKETS (1995 TO PRESENT)

Source: Bloomberg 8/15/14.

E M

P / E V S . D M

P / E

1995 1998 2001 2004 2007 2010 2013

0.0

0.3

0.6

0.9

1.2

1.5



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As investors have come to accept the inevitability of slowergrowth in China, they have gradually lowered the multiple onChinese equities. Today, at roughly 1.25x book value, Chineseequities have already discounted a signicant slowdown inthe economy and then some. Current valuations are consis-tent with a growth rate of approximately 6% to 6.5%, ratherthan the 7.5% that was recorded last quarter, a rate consis-tent with the central governments target. To the extent inves-tors become comfortable with growth of just 7%, or even a bitless, there is actually some room for Chinese multiples torerate higher from current levels.

SLOWER THAN BEFORE, FASTER THANTHE RESTElsewhere in Asia, fundamentals are not only stabilizing butin a few noticeable instances improving. Compared to otherregions, emerging market countries in Asia appear to beexperiencing a more pronounced cyclical upswing. Forexample, while Indias growth rate remains well below the10% it briey hit several years ago, it has recovered from itsrecent slowdown. Second quarter GDP increased to 5.7%,signicantly higher than rst quarters 4.6% and comfortablyahead of analyst estimates.

Improving growth is also evident in the recent improvement inmanufacturing surveys, which have turned higher in contrastto those in Latin America and Eastern Europe (see Figure 8).Given Asias large trade sector, the region is also likely to bethe biggest beneciary of the recent upturn in U.S. growth.

The relative resilience of these economies is also evident

when you compare earnings surprises in EM Asia with therest of the EM universe. By and large, EM Asia comes outahead (see Figure 9).

FIGURE 7: CHINA GROWTH VS. VALUATION(2004 TO PRESENT)

Sources: Bloomberg 8/14/14.

S H A N G H A I C O M P O S I T E P / B

CHINA GDP ANNUALIZED (%)

6 7 8 9 10 11 12 130

1

2

3

4

5

6

7

FIGURE 8: PMI IN EM REGIONS

Source: Haver, Citi Research.

( P M I )

2009 20112010 2012 2013 2014

Asia PMI LatAm PMI EMEA PMI

40

45

50

55

60

65

FIGURE 9: EARNINGS SURPRISES IN EM ASIA

CountryNumber

of Stocks

Analysts2014

EarningsGrowth

Estimates (%)

Changesto

Estimates 90 Days

(%)

Changesto

Estimates 60 Days

(%)

Changesto

Estimates 30 Days

(%)

EmergingAsia Pacic 1791 8.4 -1.6 -1.2

-0.6

Taiwan 141 7.8 4.9 3.5 0.7

China 966 10.4 -0.7 -0.6 -0.3

India 200 5.9 0 0.1 0

Indonesia 69 5.9 -1.5 -1.1 -0.4

Korea 168 7.9 -9.5 -7 -2.5

Malaysia 87 5.6 -3.3 -3.4 -3.2

Pakistan 13 11 -6.1 -0.8 -3.4

Philippines 50 5 -3.3 -1.9 -2.2

Sri Lanka 2 4.7 -5.4 -5.5 -1.9

Thailand 75 6.1 -1.9 -2.2 -0.7

Vietnam 11 5.5 -6.7 1.7 0.2

Source: StarMine Professional, as of August 20, 2014. The table looks at smart-weighted analysts earnings-per-share estimates for 2014 with the weightingreecting consensus, but weighted according to the varied success rate/credibility ofthe analysts, followed by respective 90-, 60- and 30- day changes to those estimates.



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Admittedly, part of this is a matter of relative performance.Consensus earnings-per-share (EPS) downgrades have notbeen as signicant for EM Asia as they have been for Europe.On a year-to-date basis, Korea and Vietnam consensusearnings have been downgraded the most while Taiwan hasbeen upgraded the most. China EPS consensus expectationshave stayed steady and this quarters earnings have been

mildly positive.

OF TOUGHER STUFFThere is another dimension across which Asian EM countriesscore better than their counterparts in Europe and LatinAmerica: By and large, they are less sensitive to changes inglobal capital ows. With the exception of Indonesia andIndia, all the major countries in Asia run, often sizable,current account surpluses (see Figure 10). And even in thecase of India and Indonesia, both countries have postedsignicant improvements in their current accounts.

As a result, the region has been and is likely to continue to bein the future more resilient to higher U.S. yieldsshould theyever actually riseand any potential interruption of capitalinows. In comparison, despite moderate current accountadjustments, Latin America and EMEA are still running largedecits, and remain vulnerable to ight-of-capital if theFed raises rates sooner or more aggressively than expected(see Figure 11).

STILL ROOMMany emerging markets are up dramatically from their springlows. Brazil has rallied approximately 35% from the March

bottom while India has advanced more than 20% over thesame time frame. Even China, which continues to lag globalmarkets, has gained about 10%. This leaves the questionof whether or not the price adjustment has already occurred.Our view is that there is considerable room for further gains,particularly if we continue to see improvement in theglobal economy.

While EM Asia, along with other parts of the emerging marketspace, has advanced and actually outperformed since thespring, this follows several years of underperformance andnegative sentiment. Flows have turned over the past severalmonths but were negative for the rst quarter and all of 2013

(see Figure 12).

FIGURE 10: ASIA CURRENT ACCOUNTS

Source: Thomson Reuters Datastream, Oxford Economics, Black-Rock Investment Institute as of 8/18/2014.

( % O

F G D P )

200920082007 20112010 2012 2013 2014

South Korea Malaysia PhilippinesChinaIndonesia

-5

0

5

10

15

20

FIGURE 12: REGIONAL AND TOTAL EM EQUITYFUND FLOWS

Source: EPFR, Credit Suisse Research.

( U

. S . $

B N )

AsiaEMEAGEM Total EMLatinAmerica

YTD (U.S.$bn) 2012(U.S.$bn)2013 (U.S.$bn)

-20

0

20

40

60

FIGURE 11: LATIN AMERICA CURRENT ACCOUNTS

Source: Thomson Reuters Datastream, Oxford Economics, Black-Rock Investments Institute as of 8/18/2014.

( % O

F G D P )

200920082007 20112010 2012 2013 20152014

Argentina Mexico Brazil PeruChile

-6

-4

-2

0

2

4

6

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As China growth fears have abated, fund manager allocationtoward EMs has turned more positive, but still remains wellbelow the long-term average. In addition, looking at theregional breakdown, despite the recent reversal in ows, thecumulative year-to-date fund ows for all three EM regionsare still negative. In short, it is difcult to argue that any partof the EM space represents a crowded trade.

CATALYSTS AND RISKSAsian emerging markets have already beneted from adiverse list of catalysts: stabilization in Chinas economicdata, elections in India and Indonesia, as well as a benignrate outlook. Looking out over the next 6 to 12 months, weconsider what other potential catalysts may help drivethese equity markets still higher.

In most of these markets, policy will still be a dening factor. Tobe sure, the sense that the region is essentially on the right trackwith respect to reform is par t of what has helped EMs rally thisyear. The elections in India and Indonesia produced market-friendly outcomes in two of Asias most important markets.

But how these new governments implement policy will have asignicant impact on the future direction of these markets. InIndonesia, after Joko Jokowi Widodos win the focus will likelyshift to his ability to build a coalition in parliament. If the PDI-Pruling party is able to bring together some of the major otherparties, investor condence in Jokowis ability to push aheadwith energy sector and institutional reform is likely to increase.Similarly, in India, any evidence of progress on structuralreforms, particularly those that address Indias chronic lack ofinfrastructure, should be greeted as market-friendly events.Other potential catalysts would include evidence of scalconsolidation, particularly if accompanied by a drop in ination.

Finally, events in China will also be a key driver for the region.Watch for reform references at the Fourth Plenary Session inOctober, specically with respect to legal reforms to supportthe anti-corruption campaign, which is critical toward creatinga functional marketplace in China. Another event to watch isthe APEC Economic Leaders Meeting in November in Beijing,which focuses on regional integration and expanded trade,but China could also pledge further reforms at the meeting.

The risks for the region, both in terms of fundamentalgrowth as well as investor sentiment, are largely tied toChina, specically the real estate market. While we believethe fear of a property slump in overdone, risks remain.Investors should pay careful attention to both propertyprices and loan growth. Ideally, both will decelerate in agentle fashion that does not undermine the broader economy.

The good news is that despite the risk, a number of factorsshould help avert a major property slowdown. To begin, thereis anecdotal evidence that local governments are enactingmeasures to shore up property markets. In addition, demandremains strong thanks to a desire to upgrade from poorly builtabodes of the past and, at least as of yet, there are few signsof stress in tier 1 cities. Furthermore, mortgage loans in Chinatypically have a down payment of 30% or more, making theleverage in the formal banking sector relatively low. Finally,in a worst case scenario, the central government can, andis likely to, bail out the banks using its vast balance sheet.

CONCLUSIONOpportunity is missed by most people because it isdressed in overalls and looks like work.

Thomas Edison

One of the primary investment challenges today is ndingan asset class that is neither expensive nor toxic. Nearly sixyears of extraordinary policy by the worlds central bankshas left virtually every asset class at fair value or well above.Broadly speaking, emerging market equities are an exception.While not particularly cheap on an absolute basis, for the

most part the asset class trades at or below its historicalvaluation. Within EMs, Asia offers a good combination ofreasonable valuations, improving fundamentals and poten-tially positive catalysts.

Growth is likely to outshine other par ts of EMs and, with thenotable exceptions of India and Indonesia, current accountsurpluses suggest that these countries are less vulnerable tohigher interest rates. Finally, while earnings growth remainsmuted, it is leveling out versus developed markets.

That said, risks remain, most notably the extent and depthof Chinas debt and real estate problem. However, for now

we believe the risks are contained and mostly discounted inthe price of Chinese banks, although Chinese property andbuilding companies may still be vulnerable. While EM Asiais not without its risks or downsides, it offers somethingexceptionally rare in todays market: the potential for anundervalued asset class.

While EM Asia is not without its risksor downsides, it offers somethingexceptionally rare in todays market: the potential for an undervalued asset class .

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BlackRock-Emerging Markets-A Closer Look Market Perspectives-October2014