By Bo Bejstrup Christensen, chief analyst at Danske Invest
In July, we argued for reducing exposure to the emerging markets. The concern at that time being an expected decline in growth in China, and also a likely interest rate hike in the USA. Initially, the emerging markets were affected more than e.g. the US and Europe, but especially in August shares essentially fell throughout the world.
As we have previously stated, we have taken the first step to generally increase our exposure to equities, and with this decision we also stepped back into the emerging markets. Why?
China is not a lost cause
The catalyst of the turmoil in August was China's decision to allow its currency to depreciate. This was followed by disappointing Chinese economic data, and recently the American economic data has also been weak.
The broad picture is that China's growth has geared down further, and our assessment now is that the pessimism regarding China is so great that it is comparable to panic. A concrete example hereof is that the Chinese equities listed on the Hong Kong exchange last month were traded at a price/book value almost equivalent to the level as when they hit rock bottom in the wake of the financial crisis in 2009.
This is a strong indication that the market has prepared for a potentially unpleasant scenario in China. And this scenario is very different to our expectations.
We believe that the stabilisation of the Chinese housing market and the government's focus on easing e.g. fiscal policy will steady growth during Q4 and into 2016.
If we are proven to be right, this can give some stability not only to the Chinese financial markets, but also to e.g. commodities prices, to the benefit of the rest of the emerging markets.
We should not fear the Fed as much as before
We have twice been mistaken concerning the timing of the American interest rate hike. It is very likely that the Fed will postpone the interest rate hike until 2016, although we currently assess that it will happen in December. However, our primary message is now – in contrast to previous statements– that the interest rate hike should not present a major challenge for equities.
Growth in the USA has actually declined. In our assessment, it has fallen from 3% to just over 1.5%. We currently assess that this relates to the effects of the new drop in oil prices and how the manufacturing sector is facing a classical stock correction whereby it, for various reasons, finds it necessary to reduce stockpiling and increase some liquidity.
If we are also right that the unrest on the financial markets does not significantly affect the banking system, American growth must get back up into a higher gear.
Expanding growth in the USA is typically a positive scenario for global equities. This will support global trade, which has been weak for a long time, and will enable the Fed to raise the interest rate. But even if the Fed raises the interest rate for the right reasons – on the basis of sound growth – this should not present the same challenge for the emerging markets as would have been the case if the Fed had raised the interest rate in the context of declining Chinese growth and moderate American growth.
We have come a good way in the adjustment process
We have long been concerned about the currencies in the emerging markets, as we have viewed them as pressure valves to relieve the pressure that has built up in several countries. In view of relatively strong domestic demand, driven by e.g. an expansionary monetary policy combined with weak exports, several countries faced external imbalances in the form of trade deficits. Given the unwillingness to tighten e.g. fiscal policy in order to gear down domestic demand, and thereby imports, the currency became the pressure valve needed to make imports more expensive and thereby reduce the trade deficit.
At the same time, several economies were affected by declining commodities prices and thereby recession, which in turn helped to reduce imports, albeit to the detriment of exports. The result is thus that while the trade balances gave rise to concern a few years ago, they are now closer to balance. All other things being equal, this means that the pressure on currencies has diminished, although in our view it has not disappeared entirely.
Adding together the three factors of better growth in China, an interest rate hike in the USA in a context of higher growth, and reduced pressure on currencies, we can now argue for a neutral exposure to the emerging markets. Since we are now, generally, optimistic with regard to globally risky assets, we also believe that the worst is over for the emerging markets in this round.
So why not buy up as much as possible?
The obvious question is thus why not overweight the emerging markets? Fundamentally, we still have three concerns regarding the emerging markets.
First of all, we are still sceptical about the long-term prospects for China. Even though we do not expect a collapse in the immediate future, China still faces major challenges in the form of stagnating construction activity and a banking system that, to put it bluntly, is the long arm of the state. It wishes to put a damper on overall growth and thereby not contribute to the rest of world to the same extent as before via e.g. commodities demand.
This also makes us – which is the second concern – less optimistic about global commodities prices and thereby the development for many countries in the emerging markets.
Thirdly, we assess that even if the emerging markets in overall terms are relatively inexpensive, this pricing reflects a high degree of divergence. Some things are relatively inexpensive – e.g. Chinese banks– but these are also the sectors about which we are most sceptical, in a long-term perspective. On the other hand, there is – unfortunately - still a tendency for the good stories, such as Chinese Internet companies or Indian consumer goods companies, to be priced relatively highly.
There is no doubt that it is possible to find pockets of good and attractive investment opportunities in the emerging markets, but in our view the overall market is not quite as inexpensive as it looks.
What will it take for us to change our view and buy up even more in the emerging markets? We would like our China scenario to be confirmed; and if the uncertainty concerning the growth prospects for the emerging markets diminishes in the face of increasing American growth, thereby discounting an American interest rate hike, this might potentially cause the skies to clear even more for the emerging markets.
Right now, however, our primary message is that a lot of people panicked. In our view, this panic is not justified, so that the prospects for the emerging markets are rather more positive than has been the case for some time. As investors, we can therefore dare to dip our toes again, which is precisely what we have done.
By Bo Bejstrup Christensen, chief analyst at Danske Invest