Valuations are attractive. BofA’s latest analysis comparing PB with ROE less COE suggests emerging markets (EMs) are 20% undervalued. Large sectors in bigger markets look particularly undervalued, most with a “state capitalism” discount. Potential reforms from these governments could unlock this discount. 2) Sentiment is sour, as the BofAML Fund Manager Survey indicate. 3) The EM growth cycle is picking up. 4) Tactical China indicators are bullish: China economic surprises, Shanghai property stocks, Shenzen small/mid-cap stocks, fine wine prices and China’s EPS revisions, are all stable/rising. 5) Asia’s terms of trade are rising, presaging improving EBIT margin growth.
Four challenges EMs are focused on
First, US bond yields almost always rise around transitions in the Fed chair. Second, the markets are concerned about the withdrawal of US quantitative easing. Indeed, EM equities are trading like US homebuilders, united by concerns of US monetary tightening. Third, oil prices are higher. For most large EMs, this is a drain on their balance of payments, and if subsidized, on their fiscal accounts. Fourth, a stronger USD and a narrowing US current account deficit form a combined strong negative for EMs. David Woo, BofA’s chief FX strategist, points to higher US energy production, aging boomers buying domestic services over imported widgets, and a cost-driven US manufacturing renaissance helping to narrow the current account deficit. A shrinking US current account deficit is associated with EMs crises, as USD-short entities scramble for USD.
Ascertaining financial vulnerability: This is not 1997
Financial vulnerability is often driven by credit booms, mal-investment, international illiquidity and worsening external accounts. Of the 14 EMs BofA analyzed, eight (or 60%) are demonstrating heightened financial vulnerability – less than the 80% in mid-1997. Fewer markets are impacted today, and it is not yet at the severe levels of 1997. This is not 1997.
OW: Korea, Russia, China, India; UW: Mexico, Malaysia, Thai, Chile
Korea: Value, low financial vulnerability, rising terms of trade, rising EPS revisions. Russia: Inexpensive, out-of-favor, oil theme. China: Out-of-favor, improving data, inexpensive, rising EBIT margins. India: Among the highest FCF /sales ratio in EMs, and looks 15% undervalued. Our country-sector stances are detailed inside.
A closer look at India
India seems to reform under duress. OW is a value call, supported by panicked sentiment, a competitive rupee and the new reform-oriented RBI chief, Raghuram Rajan. Long term, (1) India has a rising Demi-Ashton ratio, which correlates with long-term real equity returns. (2) It has under-invested in terms of capex/GDP, a contrary indicator for prospective EBIT margins. (3) The electorate is pro-growth, removing incumbent governments that do not deliver on growth, so elections in mid-2014 should yield a pro-reforms government. Lastly, debt-laden firms have corrected a lot (only about 12% of market cap now) and are not a key issue anymore.
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