Emerging markets assets to benefit from risk re-pricing
16 October 2013
Category: News, Global, USA, Emerging Markets
By Herve Lievore*
Since mid-May, markets have showed heightened volatility on the back of expectations of a gradual exit of quantitative easing (QE) policies in the US. This isn’t a surprise given the major role played by these policies on almost every asset class performance over the past three years. QE policies intended to provide an incentive to investors to increase their exposure to risk assets (by depressing the return on safe haven assets). The policy was a success and risk premia fell to low levels. The prospect of an exit from QE policies in the medium term triggered a reassessment of risks, especially macro risks.
The decline seen on some assets, especially in emerging markets (EMs), reflected this reassessment of risks and, by definition, this move should be temporary if the underlying fundamentals remain unchanged. It is worth noting that, even before the Fed surprised the market by postponing the beginning of QE tapering, a broad-based rebound in returns took place in September.
The macro risks in developed markets (DMs) are well known and dominated by public debt sustainability. But EMs are also facing new challenges. The most important is the erosion of current account surpluses since the burst of the credit bubble in 2007. Countries running a current account deficit are more dependent on foreign capital, making their currency more vulnerable.
These macro risks were mispriced until recently and, given the correction over the last six months, probably no longer are. But the emergence of new sources of risks, like the US debt ceiling issue and the government shutdown, will likely fuel a certain level of risk aversion in the short run. However, it seems to us that the most likely scenario for 2014 still is a gradual economic recovery due to lower fiscal drags in most countries.
With the current economic backdrop, corporate assets are the preferred asset classes relative to top quality government bonds based on valuation and expected earnings over the medium to long term, and in the context of US QE unwinding.
Within corporate assets, equities are more attractive given their upside potential in a context of uneven global recovery. Global recovery is expected to regain traction in the second half of the year once the impact of fiscal consolidation in the US, and possibly in the eurozone, has been absorbed. Obviously, the showdown between Democrats and Republicans on the debt ceiling issue could delay this scenario.
Looking at Asia ex-Japan equities, they are now trading on valuations not much different from Europe (where valuations are supportive) without the lingering overhang stemming from the financial crisis in the US or Europe.
Depending on the index, China is both the worst and best performing market in EM Asia this year. Chinese stocks have erased some of their losses on the back of lower money market tensions, while a better prospect for profit margins and low valuation metrics could offer value in the medium term. Yet with balanced macro risks and supportive market outlook, the Chinese equity market continues to present investment opportunities.
On India, despite the strong profitability for Indian stocks, the market continued to be driven down by macroeconomic factors. While the medium to long-term prospect of Indian stocks remains intact, short-term risks are sufficient to justify a move from overweight to neutral.
The impact of QE tapering expectations have already been substantial and the postponement in September will only make the process more gradual and volatile but the upward trend in yields will continue in the medium to long term.
In the near term, treasury yields may fluctuate as markets digest the news of potential QE tapering, and re-price risk. Should spreads widen and bond markets correct significantly, this may potentially create opportunities in corporate and emerging debt markets for long-term investors; we do not think these markets are overvalued but short-term volatility is likely. We still believe high grade government bond yields are unattractive regardless of short-term movements.
Asian bonds offer resistance in terms of credit quality. Yields in EM bonds have risen since the beginning of the year amid higher US yields and, more importantly, widening credit spreads. In Asia, the bulk of the surge in yields is due to higher US yields and credit spreads played a minor role. Asian issuers offer a better risk profile relative to their Latin American or EMEA counterparts, offering a comparative advantage in times of uncertainty. However, on a longer-term perspective, EM ex-Asia bonds could offer good opportunities
With the lingering uncertainties, there’s a strong need to be selective when looking for opportunities. Also, as volatility is likely in the near term, investors are strongly recommended to stay well-diversified among asset classes which can help mitigate volatility and capture deep value investment opportunities.
*Herve Lievore is senior macro and investment strategist at HSBC Global Asset Management