Emerging bulls run out of energy

The high returns from emerging market equities and bonds looks to be diminishing and, as central banks tighten their monetary policies, caution is now the watchword for investors.

Buoyant returns in emerging markets over the past three years have caught the attention of even the most risk-averse investors. Falls by many emerging market equities and bonds in the past two months, however, raise concerns that the long bull run may be looking a little weary and that valuations are a bit stretched.

Financial markets can be fickle, so investors need to adopt a cautious approach when the amber light flashes. It is a time for investors to examine the evidence and ask themselves if they are affording sufficient risk premiums to emerging market stocks.

Emerging markets have been booming. Measured by the MSCI Emerging Markets Total Return Index, they soared by 215% over the three years to March 31, 2006. That is stellar performance by any measure. The causes are historically low global interest rates, which have created liquidity, and buoyant American consumer spending, which has propped up global economic growth.

In addition, the intrinsically-linked strength of commodity prices and investors’ acceptance of risk has led to a virtuous circle as improving current accounts have prompted bond investors to re-rate emerging market sovereign debt in what could prove a secular trend.

There are, however, some clouds on the horizon. Markets are reaching a critical point as the big central banks tighten their monetary policies. Many economists expect the Federal Reserve’s target rate to rise to 5% in May, while the European Central Bank is raising its short-term repo rate and the Bank of Japan has scrapped its five-year-long policy of quantitative monetary easing.

Tightening monetary policy is likely to absorb some of the excess liquidity in financial markets. This could increase uncertainty about international growth prospects for the remainder of 2006 and cause some unwinding of the “carry trade”, which has been beneficial in supporting emerging market securities.

There was, of course, also the presence of an inverted yield curve in America, something that in the past has suggested a slowdown or potential recession. Ben Bernanke, the Federal Reserve’s new chairman, however, has reminded us that this indicator is not a crystal ball and that it is different this time.

Financial indicators show that domestic economic growth rebounded strongly in the first quarter after a lull at the end of 2005 but any correction in house prices could lead to a slowdown. The prospects for emerging market debt could also become less attractive, emphasised by the potential for economic sluggishness.

Beyond potential political risks, bond markets could become unsettled by rising American interest rates if investors begin to shy away from riskier assets in favour of higher-quality investments.

Are these factors the red flag that signals a change in fortunes for developing countries? It is possible. The considerable inflows of assets from developed countries seeking growth opportunities and over-enthusiastic domestic investors have taken their toll and market valuations are starting to look expensive.

There have already been significant slumps in a number of key markets over the two months to March 31. Turkey suffered the most notable correction, falling 18% as measured by the MSCI Turkey Total Return Index, while the MSCI Brazil Total Return Index and the MSCI Russia Total Return Index both slumped 12%, all in dollar terms. The graph below shows the 16% fall in the MSCI Turkey Total Return Index from its highest point on February 27 to March 31.

These market corrections could be the forerunners of adjustments elsewhere. It seems sensible to reduce exposure to some of these markets.

While equity markets across the board have followed a trend upwards since 2003, this situation is unlikely to continue indefinitely. Emerging markets are not a homogenous group and country-specific factors must be considered, such as the influence of commodity prices on current account surpluses, which can afford countries a more independent stance towards currency, fiscal and monetary policies. In Latin America, for example, volatility could pick up over the remainder of 2006 because the continent will undergo seven elections, including those in Brazil and Mexico.

The Indian market may also prove unstable. Its stockmarket has performed strongly, with the MSCI India Total Return Index climbing 21% over the first quarter of 2006. Even so, there are doubts about Indian equities.

The local stock market’s price/earnings ratio of around 18 is at the same level as that of the Dow Jones Industrial Average. For an emerging market this is an impressive feat, but it could be an indication of a bubble ready to burst.

China has its own country-specific circumstances and is a market in which it can be beneficial to take a contrarian approach. Unloved by the broad mass of investors, China has cheap equity valuations that do not appear to reflect the country’s good earnings growth potential. In addition, China has agreed to adopt improved accounting standards and the political authorities in Beijing appear to be more willing to let the renminbi strengthen to help rebalance economic growth and improve trade relations with America.

After such a remarkable run, we believe that international investors do need to rethink their exposures to emerging markets, given the possibility that returns over the short term are unlikely to match their recent past performance.

It is possible that there could be a sizable correction in these markets during the second and third quarters of 2006. There will, however, be decent prospects in the long term, so markets should be monitored with care.

Timing the entry and exit points is crucial, particularly for funds of funds where asset allocation is a key driver of performance. In such circumstances, it may be time to draw breath and revisit emerging markets later in the year.