It is too much to hope for a big bounce in emerging markets

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Emerging markets have disappointed investors for at least a decade, failing to deliver hoped-for rates of economic growth and portfolio returns. Bullish analysts are now forecasting that the outperformance will come when the coronavirus outbreak recedes and markets return to business as usual.If such hopes depend on a broad recovery for the asset class, they are likely to be dashed. A selective approach may work better.JPMorgan’s Marko Kolanovic is among those expecting a rebound in EM stocks. This week, he reiterated a call to sell defensive assets — more expensive stocks that are less exposed to the economic cycle — and rotate into segments such as value stocks (judged to be cheap against their fundamentals), commodity-exposed stocks and EM. His earlier call for such assets to outperform in the first quarter had been set back, Mr Kolanovic said, by the Covid-19 epidemic. The strategist expects to be vindicated as that threat falls away in coming weeks.Mark Haefele of UBS Global Wealth Management also expects the impact of the coronavirus epidemic to be limited mainly to the first quarter. He is sticking to his call that EM equities should outperform on that basis, and in anticipation that risks from the US-China trade dispute will recede.

Valuations are not attractive enough. If the growth story fails, there is no other really compelling reason for EMs to do well.

Such calls assume markets will break out of a trend that has gripped them for at least the past two years. That is, an ocean of liquidity provided by the US Federal Reserve and other central banks pushing up the value of developed market bonds and the stocks of big tech companies and other global corporations, while cheaper stocks and markets flounder.The calls also assume that the difference in the rate of economic growth between emerging and developed economies — often seen as the biggest single driver of returns on EM assets — will begin to widen this year in favour of EM after a decade of contraction.Yet there are good reasons to think this will not happen. Robin Brooks, chief economist at the Institute of International Finance, believes emerging economies are in the grip of so-called secular stagnation — a long-term slowdown in growth. In some countries such as Argentina and Turkey, this has been caused by clearly identifiable crises. In others, it is a result of weak investment after the fall in commodity prices since 2014.Mr Brooks argues that, while consumption has held up in many large EMs, this may not be sustainable. Households could be “looking through” any downturn and borrowing or using their savings to maintain consumption, he said, adding: “If the perception grows that this is a permanent shock, foreign investors may pull their money out.”Even some analysts advocating investment in emerging markets are not doing so on the basis of a significant recovery in growth.Justin Leverenz at Invesco is in this camp. In a recent note to clients he wrote that after a decade of collapsing growth, deglobalisation and the implosion of the Brics “myth” — that Brazil, Russia, India, China and South Africa would grow strongly as a group — any recovery in emerging economies is likely to be slow and moderate.Nevertheless, Mr Leverenz expects a mean reversion towards value stocks in EM. These stocks have underperformed growth stocks since about 2012, mirroring their developed-markets counterparts, with the divergence widening for much of the past three years.Mr Leverenz also thinks the US dollar will weaken against other currencies, allowing EM central banks to ease policy more aggressively. In China, he expects the shift to consumption and private investment to be supported by greater social spending.Even if this moderately rosy prognosis is not fulfilled, there may still be opportunities.Per Hammarlund, chief EM currency strategist at SEB, says EM currencies are in an uncomfortable position of being neither particularly weak, nor particularly strong. “Valuations are not attractive enough,” he said. “If the growth story fails, there is no other really compelling reason for EMs to do well.”
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The carry trade — borrowing in currencies where interest rates are low to invest where they are high — has also disappeared from traditionally lucrative markets such as Brazil, following dramatic easing of monetary policy.The best strategy at times like these, Mr Hammarlund argues, is to exploit different valuations within EM rather than between emerging and developed markets. One example is the tendency of currencies of countries with strong macroeconomic fundamentals to outperform those with weaker ones.But in the current environment, the data suggest it is easier to gain from differences in interest rates by buying higher-yielding EM currencies to sell lower-yielding ones, Mr Hammarlund thinks. “In a global risk-off environment, they both go down against everything else but you still make money from the carry,” he said.Not a ringing endorsement of these markets, perhaps, but one way to avoid further disappointment.

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