By George Iwanicki, Macro Strategist for the Emerging Markets Equity Team at J.P. Morgan Asset Management.
The past several trading sessions have seen sharp declines in commodity prices, widening of Credit Default Swap (CDS) spreads even in Asia, and abrupt pullbacks in several Emerging Markets (EM) currencies - not to mention additional weakness in EM equities alongside the corrections in Europe and the US.
While it may be that this broadening weakness is simply a reflection of deepening global recession fears in the developed world spreading to the EM world, we suspect that the primary source of broadening risk asset weakness to the EM space is reflective of deepening liquidity pressures emanating from the unresolved sovereign debt problems in Europe and the resulting pressures on the European financial sector.
It is striking to us that even precious metals - both traditionally and over the past few years typical ‘safe havens' that find a bid when global uncertainty rises - have corrected rather than rallied during this most recent ‘risk-off' episode. This suggests broad financial deleveraging and/or liquidity pressures rather than traditional recession fears as the culprit. Of course, 2008 does remind that such an episode, left unchecked, can in its own right feedback on real economies and motivate global recession. Hence the need for policy action remains, possibly including a demonstration from the ECB or the Fed to serve as liquidity provider of last resort rather than the recent mere promises to do so.
Implications:
We continue to believe that EM fundamentals remain broadly sound, and hence do not view the developments in markets as signalling broad-based EM vulnerabilities. Having said that, developments to date reveal both risks and opportunities within the asset class.
1) EM equity has now been pushed down to valuation levels that, whatever the origin motivating the decline, have traditionally represented strong buying opportunities for strategic investors. Calling bottoms is extraordinarily difficult; but identifying windows to top up allocations if more feasible, and Price/Book values of 1.5x or below represent that for EM equities. Recent price action has pushed valuations to roughly this level. We continue to believe that downward estimate revisions (in the wake of August GDP consensus estimate reductions for US and EU) will provide a momentum ‘headwind' for global equity markets over the next couple of months but we are sufficiently impressed with cheap valuations that the window for topping up allocations has opened.
2) Commodities and commodity exporter currencies - we have long been skeptics on seeing another super cycle in commodities and the associated terms-of-trade boost to commodity exporter currencies. However, we have argued that the ‘big reversal' of the past decade's super cycle requires one of two things to occur: either global recession or an extended USD rally. The latter still looks unlikely given the Fed's recent elaboration that ‘extended period' means the next two years, the former is still not our base case even if US and Euro zone slip back into technical recession (i.e. modest negative GDP rather than the modest positive growth of recent quarters). Having said that, several of the commodity exporter currencies where we have long detected overvaluation have begun to correct; those that also benefited from carry trades have suffered the sharpest reversals (more evidence of deleveraging). Most notable is the Brazilian Real, which has long appeared to be the richest of EM currencies by our estimates. While we defer to our FX colleagues for views on near-term direction, the magnitude of the currency headwind to long-term returns for several emerging markets has been reduced by the most recent leg of risk reduction.
3) Credit risks - We can identify instances where macro risk is evidenced by either relatively high sovereign debt/GDP (Hungary, India) or currency-mismatched private debt (CHF mortgages in Hungary, the subject of recent heterodox policy there), but we still view credit risks within the asset class as largely selective rather than systemic. Even in those instances where private credit growth boomed in response to 2008-9 stimulus (China as the biggest example), we believe that the duration of rapid credit expansion was insufficient to imply a coming credit bust that debilitates growth. Again while we defer to our EMD colleagues on specific views we are more inclined to view the widening in credit spreads within EM as largely reflective of global liquidity or risk concerns rather than a systemic credit risk within the asset class only now becoming recognized.
In sum, rather than be troubled by the broadening in correction across EM equities, currencies and credit, we remain constructive on EM fundamentals and believe the window for either accumulating or adding EM equity has now been opened by cheaper valuations alongside more fairly valued currencies.
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