Emerging markets have taken a big hit recently. It’s all because of talk about ‘tapering’. At the latest Federal Reserve meeting on 20 June, the US central bank signalled it could start to wind down assets purchased in the second half of 2013, and end purchases by mid-2014.
Shareholders didn’t like it one bit, and emerging market stocks fell extra hard. This raises a big question for us: what next?
Well, despite the panic, I don’t think the long-term outlook has changed at all. Today I want to put you at ease, and tell you why I still like my favourite markets in Southeast Asia.
Since the financial crisis, the world’s central bankers have been hosing the markets with liquidity (quantitative easing). This has resulted in some unusual outcomes, summarised by Bank of America Merrill Lynch as follows:
• $12trn of financial asset purchases by the big five central banks
• 520 central bank rate cuts
• $33trn of fiscal and monetary stimulus (equivalent to 46% of the world economy)
• The lowest US government bond yields in 220 years
Concerns about tapering triggered a stampede for bond and credit investors. A sense of unease from investors can be seen in the amount of investments flowing out of funds.
Fixed income funds recorded a net outflow of $20bn last week. Far more worrisome is that US Treasury bonds are on course for their worst year since 1978; municipal bonds since 1989; and investment grade bonds since 1973. Emerging bonds reported their largest weekly outflows in history of $7.5bn.
Emerging market equity funds have been hit hard too – losing $19.9bn in June. That’s more than in January 2008 when outflows reached $18.7bn. Most of the selling comes from ‘passive investors’ (eg exchange traded funds, ETFs) in the US or Europe.
One thing that should put us at ease, though, is that over the last decade emerging market funds have recorded two big sell-offs (in 2008 and 2010) and both were followed by strong inflows the following years.
And I believe we are about to see a similar rebound again.
Four investment implications of the big sell-off
There are four things we need to keep in mind now:
Sentiment towards emerging market equities is close to rock bottom
The latest BoA Merrill Lynch Global Fund Manager Survey shows that fund managers have slashed exposure to emerging market equities to a net 9% ‘underweight’ (from 43% ‘overweight’ just four months ago), the lowest reading since December 2008. This level of bearishness tends to result in a bounce. But the timing of that is hard to call as we are now in the normal summer lull.
Emerging market bonds could see further sell-offs
The inflow to this asset class was much stronger after 2008/09 than previous periods. For instance, capital flows to bonds in Thailand were ten times higher than to equities compared with 2004-07. But such a scenario would mean that central banks find it easier to pursue their monetary policies.
To recap, liquidity inflows pressured central banks to cut rates to limit currency appreciation, and low interest fuelled higher asset prices, particularly property, triggering various cooling measures. Now there is scope to cut/hold interest rates, underpinned by weaker commodity prices which are major components in calculating inflation in Asia.
A switch from bonds to equities is on the cards
A switch from bonds to equities is likely if US economic growth continues to surprise on the upside. This will not happen without some resistance. As highlighted during the MoneyWeek Conference large institutions in the UK (insurance and pension funds) have been net sellers of equities for more than a decade and built up massive positions in bonds. Their equity exposure to emerging markets is minimal. For example, the Thai stock market has almost doubled from its lows in 2008, but foreigners have been selling. Instead, locals have pushed the market higher.
The fundamentals will matter again
Global investors will be forced to formulate a concise worldview, probably in September or October when people are back from their holidays. I believe active stock picking will pick up again where there are opportunities for growth at reasonable prices.
I remain bullish on Asian equities, particularly in the Association of Southeast Asian Nations (ASEAN), as these economies are going through investment-led growth linked to the AFTA 2015 free trade agreement – an early EU-type of economic integration allowing the ten member countries greater integration, specialisation and competitiveness.
This is something that has never been seen before in this region. It’s going to have a monumental impact on all ten countries involved. I am convinced that, despite the recent sell-off, there are big, big gains to be made here.