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This post by John-Paul Smith of Deutsche Bank is the first of 11 that beyondbrics will publish in the next two weeks addressing the big questions about emerging markets in 2011.
We are pretty optimistic that emerging market equity returns will be positive over 2011, but we expect them to underperform developed market equities. The attractions of global equity markets next year are underpinned by a relatively high risk premium against fixed income instruments and by the improving prospects for the US economy, driven by QE2 and by the ongoing improvements in productivity.
Look specifically at emerging markets and they are also cheap against fixed income, but they are valued at close to parity with their developed market peers, having traded at a discount for much of the previous decade. We feel that they should trade at a discount again, for three reasons.
First, whilst corporate governance has improved over recent years, minority shareholders still lack any real influence in most emerging markets, albeit with some exceptions such as South Africa.
Second, emerging market corporates in aggregate have high levels of operational gearing towards nominal GDP and commodity prices, neither of which are likely to grow over the next few years at the same pace as during 2002-07.
Finally, there is evidence of growing state involvement in both the economy and corporate sector across many emerging markets. This could hurt investors in a number of ways, most notably by governments forcing companies to prioritise social or geopolitical objectives over economic returns.
From an economic perspective, the main issue facing investors in emerging market equities is currently the degree of overheating, which is evident across a number of economies in the form of rising inflation and/or current account deficits.
Commodity price increases in particular have had a more inflationary impact on emerging than developed economies, because of their higher weightings in price indices and – more importantly – the narrower output gaps.
Many central banks, particularly in Asia, are reluctant to raise interest rates to an appropriate level because they are also striving to avoid any major nominal appreciation of the currency, which would damage the competitiveness of manufacturing industry.
The risks are that central banks fall further behind the curve and that corporate margins fall victim to non-monetary or ‘heterodox’ measures to curb inflation, such as price controls and loan caps.
A lot will depend on the success of the current tightening campaign by the Chinese authorities in curbing both inflation and excessive rates of bank lending. If our economists are correct that rises in food prices are the main generator of inflation, then Chinese financial markets should lead emerging equities higher, once this becomes evident to investors.
We also suspect that most active managers are overweight in emerging market assets.
If we are right to predict that the attractions of US assets, including the dollar will increase as we go through 2011, then we would anticipate a very mild unwinding of the carry trade, to the detriment of emerging markets.
We are sceptical about the widely used argument that longer-term investors are underweight emerging markets, since many pension funds have exposure to commodities and hedge funds, assets which have had strong correlations with emerging market equities over recent years.
Nevertheless, sentiment towards emerging markets is currently so strong that we cannot rule out the possibility that they will enter a bubble as we move through 2011. If this occurs, we think that the beneficiaries will be the potential issuers of equity and the investment banks who assist them, rather than investors, given that the eventual fall out from any bubble is bound to inflict real damage on the underlying economies.
John-Paul Smith is global emerging market equity strategist at Deutsche Bank in London
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