"Despite the fact that there has been little progress in resolving the underlying structural issues in the developed economies, 2012 has been a decent year for risk assets. Both developed and emerging equity markets have delivered reasonable returns against a difficult macroeconomic background. The MSCI World Index is up 13.7% year to date (as at 30 November) and the MSCI Emerging Markets Index is up 12.7% (both in US dollar terms). Over the last three months however, emerging returns have been stronger with the MSCI Emerging Markets Index up 6.7% versus the MSCI World Index which is up 3.4%.
"This is a good result given the degree of uncertainty about global growth and the clear tail risks that exist. In particular, Europe has made little progress in terms of dealing with its sovereign debt issues or the major balance of payments problems and the disparity in competitiveness that exist between member states of the eurozone. Moreover, the US has been hindered in addressing its budget deficit by the presidential election and partisan opinions on the trade-off between tax increases and entitlement reductions. Finally, the slowdown in Chinese growth over the last year or so has resulted in elevated concerns that the economy will suffer a hard landing.
"What has clearly helped however, is the continued support in terms of abundant liquidity and other measures provided by central banks. Specifically, the US Federal Reserve announced its third round of quantitative easing (QE3) during September and arguably we will get ‘QE infinity’ if growth remains weak and unemployment stays high. In Europe, Mr. Drahgi announced in late July that the ECB would “do whatever it takes” to save the euro and followed this with the Outright Monetary Transactions (OMT) bond buying programme announcement in September. These measures have helped contain peripheral bond spreads and support equities."
2013: Continuation of “muddle-through”
"So what does this mean for global emerging markets (GEMs) next year? In all likelihood we will get a continuation of the muddling through and more of the same for equity markets. In other words, anaemic developed world economic growth (but much stronger emerging activity), plenty of liquidity, record low interest rates and generally positive equity markets. However, there is likely to be much dispersion of returns between markets, punctuated by periods of tail-risk uncertainty. In terms of the economic outlook, we expect the US to deliver around 2% GDP growth next year, the eurozone to shrink a further 0.3% but GEMs to experience a modest increase in GDP from around 4.7% this year to approximately 5.2% in 2013."
GEMs to perform well in 2013
"More specifically, we expect emerging market equities to deliver solid performance during 2013 and perform even better over the longer term. There are several reasons for this. First, taken in isolation, GEMs look extremely attractive in terms of valuations, both absolute and relative to history as well as on a market capitalisation to GDP basis.
"For example, the forward price-earnings ratio (PE) for GEM currently stands at around 10 times, compared to an historic forward multiple of above 12 times.
"Moreover, in terms of market capitalisation to GDP, emerging markets are trading at more than one standard deviation below the historic average. This measure has usually been a very good indicator of long term over- or undervaluation.
"Second, two of the three most significant headwinds for risk assets in 2012 should begin to fade as we progress through next year. Specifically, Chinese economic growth appears to be responding to the modest easing measures that were implemented earlier this year. Third quarter GDP growth was up 7.4% year on year and there were signs that the economy was gaining momentum in the second half of the quarter. In particular, exports, consumer spending and leading indicators all suggest that the third quarter may have marked the bottom in terms of economic activity. This is further supported by the most recent fourth quarter data and by the apparent stabilisation of the property market.
"With inventories in many areas of the economy back to more normal levels and a new leadership about to take over in China, there is a strong possibility that concerns over a hard landing for the economy will fade early next year.
"We will also have a resolution to the US ‘fiscal cliff’ debate early next year. Our base case is that a compromise will be reached, even if it goes to the wire, and that the fiscal drag next year will be around 1.5% of GDP. This should translate into overall growth of around 2% in 2013. Whether this turns out to be correct remains to be seen, but at least the uncertainty created by this issue will be largely removed in the near future.
"The one remaining major overhang for markets is the eurozone crisis. In our opinion, this continues to represent the biggest risk for equity markets, including GEMs. As mentioned above, we are assuming a muddle-through scenario which means Greece stays in the eurozone, Spain asks for and receives a bailout and the eurozone experiences a mild recession. If this proves to be the case and the ECB manage to continue containing bond spreads, the direct economic impact on emerging markets is expected to be relatively muted. Exports to the eurozone are not that significant for the major emerging market economies. Obviously the three Central European economies are the most exposed, but we continue to have only limited exposure to these markets.
"Given the deep-rooted imbalances and fundamental problems within the region however, it is highly likely that there will be a major scare at some point next year that will disrupt equity markets. This could easily emanate in Spain or possibly Italy, but could equally be triggered by a loss of confidence in France. If French bond yields were to rise sharply then the euro would come under significant pressure and all equity markets would almost certainly sell off aggressively, including GEMs."
Cautiously positioned with a quality bias
"So how are we positioned for next year? Given that we believe the Chinese economy has stabilised and will see a modest recovery next year and that tail risks in the developed world have been reduced for now by central bank policy, it is possible that we will get a trading rally in some of the more cyclical markets and stocks as we enter 2013. But we are fundamental investors, not traders, and continue to believe that the best returns in 2013, which we expect will be another year of uncertain low economic growth and zero interest rates, will continue to be generated by companies that have strong business models and quality growth at attractive valuations. Consequently, the portfolio remains somewhat cautiously positioned with a quality bias. For example it has a higher return-on-equity (ROE) than the overall market, earnings per share growth that is in line and a PE that is lower than the index.
"Further out, we believe that the current risk aversion and cautious positioning with regard to equities will change significantly. Arguably, bond yields are being held at extremely low levels by central bank policy and are probably in bubble territory. It is quite likely however, that the unlimited money printing being pursued by the major central banks will keep interest rates at extremely low levels for quite some time to come. This may even be accompanied by financial repression as financial institutions and pension funds are forced by regulation to hold more in fixed income products despite their overvaluation than they otherwise would. But once deleveraging in the developed economies has run its course and rates begin to rise as economic activity normalises, the stage could be set for a powerful rally in equities. In such an environment GEMs should do extremely well due to their higher beta, attractive valuations and better fundamental growth prospects. The equity risk premium for GEMs is close to its all-time high at around 9%. So, in our opinion, the cult of equity is not dead, simply snoozing."
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