Fate of Emerging Markets hangs in the balance

In the short to medium-term (1-5 years) there is no doubt that pressure will be maintained on the economies of emerging markets from the Asia-Pacific region, to Africa and Latin America. Chinese demand for raw materials and other resources, notably energy and mining, has diminished. This has been reflected by the declining GDP figures for December 2015, and the year that passed. That China’s annual GDP dropped to 6.9% for 2015 is notable, and it is the worst performance of the world’s second-largest economy in decades.

EM and developed markets on opposite ends of the spectrum
This news has sparked tremendous concern among financial entities including Goldman Sachs which recently announced that pressures in China will likely lead to five years of economic hardship for emerging market economies. The global investment enterprise cautioned its clientele to readjust their financial portfolios to limit their exposure to emerging markets. This trend has been taking place for quite some time and is evident in the declining share of Asian equities, African equities and South American equities in the financial portfolios of clients. Investors have been cautioned to consider the facts when contemplating investing in emerging market economies: Russia, China and Brazil are bear market economies and their performance from April 2011 to mid-January 2016 has revealed a -40% return. Compare that to a +44% return for US equities and it is clear where the safe money really lies.

Bulls try to charge in Bear Market
The question is: why are emerging markets faring so badly? For one, the US dollar has consistently performed above expectations. The US economy has shown increasing strength over time with unemployment dropping to 5%, growth continuously inching higher and inflation slowly but surely moving towards the benchmark rate set by the Federal Reserve Bank. All of these factors combined with the December 16 rate hike by 25-basis points to 0.50% for the federal funds have resulted in a bleak outlook for EM currencies and a bullish outlook for the USD. But the big stinger for EM economies is weak global demand brought on by China weakness. Commodity prices, notably crude oil, have been hammered in 2015 and pummelled in the first three weeks of 2016. Crude oil crashed through the critical $30 per barrel support level in the third week of January, but bounced back on Friday to settle above $31 a barrel as bullish sentiment from the European Central Bank and the Chinese authorities helped to stem the rout.
So severe is EM weakness that the MSCI ACWI (the global stock market index) has slid into bear market territory. Declines had reached 20% across the board by Wednesday, January 20. Other exchange traded funds such as the Schwab EM Equity Fund declined a full percentage point in Q4 2015 and lost as much as 16% during the course of 2015. Nonetheless, it is not all doom and gloom for emerging markets over the long-term, but now is definitely not the time to see substantial gains being generated as further setbacks are likely to take place before the eventual turnaround in years to come. If we look at things like valuations, it is clear that the P/E ratio for EM equities has consistently underperformed the P/E ratios of developed economy equities by a figure of 20%. There was a period during which EM stocks proved to be highly valuable investments, but that was between 2000 and 2007.
In terms of valuations, the lower the number the better the value for the stock, but volatility may be a factor. Consider these stocks and their associated valuations:
• The P/E ratio for Indian stocks hovers around 19
• The P/E ratio for Chinese stocks hovers around 57
• The P/E ratio for the MSCI South Korea index hovers around 10
One cannot ignore the deeper implications of a Fed rate hike on the EM economies. The stability that countries like the US and Canada have is far more than mere currency strength brought upon by a rate increase; the strength of the US economy is structurally-based, and is fully compliant with regulatory requirements. The problems in developing countries include political instability, structural weakness, lack of an efficient and effective economic framework and high volatility. In the case of South Africa, there are also other concerns such as a failing power grid which cripples the economy.
But the weakness in emerging markets is unlikely to last indefinitely. As a case in point, the aging population in China will likely give rise to a growing middle-class which will require health care in the next decade. This will open up the pharmaceutical sector in a big way. The Chinese market may well become the world’s second most lucrative pharmaceutical market, despite weakness in commodities. Investors who adopt a strategic approach to EM economies are unlikely to be disappointed as growth is bound to take place as these economies gradually develop their own middle classes.

World indexes for the year-to-date
• Saudi Arabia -21%
• Argentina -19%
• Egypt -18%
• Russia RTS -17%
• Greece ATHEX Composite -17%
• SSE Composite -16%
• FTSE MIB -15%
• Nikkei -14%
Chinese equities, for example, are not cheap at all, and they need to undergo additional weakening before any value can be gained. Between 2016 and 2020, Chinese equities could weaken by up to 8% a year before they come in line with corrective valuations. More concerning to EM economies is the fact that China will likely devalue its currency to remain competitive in export markets. This will mean that China will be undercutting its competitors which are largely EM economies. For now, the smart money is on the developed economies of the Eurozone, Japan, the US, Canada and other Asia-Pacific western countries.