In a media interview earlier this year (https://economictimes.indiatimes.com/markets/expert-view/outlook-for-2019-is-much-better-than-that-of-2018-amisha-vora-prabhudas-lilladher/articleshow/67335879.cms) , we had pointed out to a potential out-performance of emerging markets over the year. Has it begun to happen?
Recent Fund Flows
The Emerging market equities (EEM) have been off to a strong start overall in 2019, rebounding from a sharp 2018 downturn, with the MSCI Emerging Markets equity index up 9.2 percent so far this year.
The first two months attracted large inflows into emerging market ETFs despite the near term negatives around trade and elections. Emerging markets sucked in a further $25.6 billion of foreign fund flows in February, a slimmer volume than January, but enough to signal investor sentiment remained positive, according to Institute of International Finance (IIF) data. The iShares MSCI Emerging Markets ETF and iShares Core MSCI Emerging Markets ETF, which are the most popular for this category, attracted $2.5 billion and $5.0 billion in net inflows, respectively, according to ETFdb data.
In particular, large flows into South Africa ($16.4 billion) and India ($13.3 billion) were behind the surge in overall inflows.
Performance of EMs
| Country | % Weight | ETF | % Change 12 months | % Change 6 months | % Change 3 months | % Change 1 month |
| China | 31.55% | MCHI | -15.90% | +0.54% | +6.22% | +4.83% |
| South Korea | 13.9% | EWY | -15.82% | -0.71% | +5.86% | +4.43% |
| Taiwan | 10.95% | EWT | -11.70% | -8.65% | -1.01% | +3.25% |
| India | 8.32% | INDA | -8.94% | -9.33% | -0.22% | -2.11% |
| Brazil | 7.82% | EWZ | -3.91% | +31.49% | +9.76% | +1.3% |
| South Africa | 6.1% | EZA | -27.16% | +1.75% | +2.62% | -1.3% |
| Russia | 3.77% | ERUS | -6.4% | +8.53% | +1.14% | +1.41% |
| Mexico | 2.72% | EWW | -15.72% | -11.85% | +9.12% | -2.57% |
| Thailand | 2.45% | THD | -7.82% | +3.81% | +5.24% | +5.42% |
| Malaysia | 2.34% | EWM | -11.84% | -3.09% | +3.06% | +2.75% |
| Indonesia | 2.25% | EIDO | -11.33% | +16.80% | +9.92% | -1.26% |
| Poland | 1.18% | EPOL | -14.89% | +2.35% | +3.07% | -2.13% |
| Chile | 1.12% | ECH | -15.12% | +5.10% | +6.26% | +0.96% |
| Philippines | 1.1% | EPHE | -6.56% | +8.79% | +17.08% | -0.29% |
| EEM Overall |
-13.89% | +1.07% | +4.51% | +2.67% |
This follows 5 consecutive months of outflows and then a $20.9 billion inflow in January.
These events look likely to restart a Wall of Money to EMs and according to some sources, high frequency flow trackers are already picking up a sharp spike.
The Main Drivers for Optimism
Easing Macros
A dovish shift from the United States Federal Reserve, easing China-U.S. trade tensions and fading anxiety about global growth had helped buoy investors about the outlook for emerging markets,.
Major asset managers and investment banks like JPMorgan, Citi and BlueBay Asset Management, among others, have been piling into the emerging markets in recent weeks. According to the Institute of International Finance, flows to emerging market assets in mid-February soared close to levels last seen in late January 2018, or days before emerging and global markets plunged, after the Federal Reserve revealed a more dovish stance on monetary policy.
Valuations
The group of emerging markets trades at about 11 times forward earnings which in terms of earning yield implies that emerging market equities are expected to generate an underlying 9.18% of their market value versus the 6% forward-earnings yield on the S&P 500 or almost a yield spread of 6.49% above the US Treasury-bond. At 1.6 times book value , valuations appear reasonable vs the MSCI World Index, which tracks large- and midcap equity performance across 23 developed-market countries, had a forward P/E of 14.5 and a P/BV of 2.3.
There have only been two other times in the past 40 years when the emerging markets earnings yield has drifted much higher: in 2002-3, after the worldwide market that followed the tech collapse, and in 2009, during the financial crisis.
Growth
Based on a study by PricewaterhouseCoopers Global, the seven largest emerging-market economies could grow around twice as fast as the Group of 7 on average in the years ahead.
Potential Upgrades
Actual performance of corporate earnings expectations , as measured by upgrades, has also begun to improve with the average forecast for profit at companies in the MSCI Emerging Market Index rising for the last 10 days into February 28, , the longest streak since January 2018. That means analysts, who had cut their projections by 10 percent in as many months, are finally letting go of their pessimism and joining investors to wager on a growth revival in developing nations.
Euro presenting Profitable Carry Trade
Using the euro as a funding currency and being long EM is a strategy being deployed aggressively because it helps to circumvent or take out some of the trade-war risk on carry trade. Given the downward momentum of the euro zone’s economy , Brexit related fears, and negative rates , it has become a virtually low trade. The attraction of using the euro is that the currency tends to decline when trade tensions between the U.S. and China escalate because Germany, Europe’s biggest economy, has a high export content to China. The euro’s three-month deposit rate of minus 0.34 percent compares with 2.63 percent for the dollar, meaning the shared currency would need to strengthen about 3 percent to wipe out gains which is unlikely.
Why EM Strength is good for Indian Midcaps
In a previous blog, we had written about the strong relationship between the EM indices and Indian midcaps. (https://www.plindia.com/blog/indian-midcaps-track-this-index-to-know-trends/). This correlation is enhanced especially if the dollar weakens – which is widely anticipated the minute Brexit / China/ Slowdown in corporate earnings begins to show up and may propel EMs higher.
While near term tensions related to the India Pak conflict, Trumps stance on China, the Brexit etc all dictate caution, it is beginning to look like a cautious but sure approach to accumulating quality Midcaps may start paying off.
Our top picks and high conviction ideas in this space are presented in our latest India strategy report available at https://www.plindia.com/ViewReport.aspx?rpt=2891
Do write into us at advisorydesk@plindia.com for advice on portfolios or to exchange views!
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