Asset markets have settled into a gentler pattern in recent days, erasing a sizable portion of the losses suffered during the first five or so weeks of the year. The rising tide has extended to that most battered of asset classes: emerging markets. This asset class has been the big underperformer among equities for more than a year now, ending 2013 with a loss even as the S&P 500 gained more than 30%.
With relative valuations so low, many market participants see a potentially attractive buying opportunity in the works. Our views are a bit more tempered: while we would not necessarily be surprised by a spurt of outperformance in the near term, we think the fundamentals argue for proceeding with caution.
For the better part of the 21st century emerging markets have been the global economy’s growth engines; in many years enjoying double-digit real GDP growth. Millions of Brazilians, Chinese, Indonesians and Indians ascended into a rapidly expanding middle class, bringing prosperity not only to local businesses but to S&P 500 titans as well. Many of the largest U.S. companies earn more than half their revenues and profits from their overseas activities. But recently, the growth trend has markedly slowed down. Brazil’s real GDP growth in 2013 was a paltry 2.2%. Turkey, which as recently as 2011 was growing at a double digit clip, is looking at potentially sub-1% real growth this year. Even India, one of the strongest emerging markets, is languishing in mid-single digits.
Flight of the Creditors
Debt was always lurking under the surface during the heady growth years. Foreign creditors were more than happy to lend to emerging markets businesses and consumers, much of which was in hard currencies. As external debt rose on emerging corporate balance sheets, other troubling data points like inflation and swelling trade deficits appeared as well. In sharp contrast to the sub-2% inflation rates seen in most developed economies, price index gains are currently more than 6% in Brazil, Russia and India. A more extreme case is Turkey, where an inflation rate of 11% helped spark a credit market exodus that spread to South Africa, Russia, India and Brazil. As creditors fled, local currency rates plunged, making those debt-laden balance sheets even more onerous.
The China Question
Looming over the whole emerging markets debate is China. The world’s second largest economy continues to grow: its 2013 GDP rate of 7.7% was the largest among the 42 major developed and emerging markets tracked weekly by the Economist Intelligence Unit. What concerns investors, though, is where most of the growth is coming from. China’s leaders have committed to rebalancing the economy away from investment (much of which is speculative rather than productive in nature) in favor of more domestic consumption. Consumer spending accounts for just 35% of China’s GDP, as compared to 70% in the U.S. But that rebalancing will be tricky, involving a cooling off of the country’s overheated financial system as well as unpopular political decisions.
These are some of the key issues giving us pause in regard to emerging markets. We remain underweight in the asset class, and will remain so until we have more evidence of the case for growth. That evidence will need to include some indication that Xi Jinping and his economic policy team are successfully maneuvering their way through the China rebalancing challenge.
On February 3rd the S&P 500 experienced its most severe pullback since the period from May 21 – June 24, 2012. Oddly, the magnitude of the pullback was exactly the same to within two decimal points: -5.76% in each case. Here at MVCM we use 5% as a marker for a pullback worth recording in our records of peak-to-trough movements going back to 1951. If the S&P 500 rallies by 5% or more without falling below the 2/4 close, then these Bobbsey Twins pullbacks will each merit a small, slightly amusing shout-out in the time-honored annals of Wall Street weirdness.
U.S. equities indexes may indeed bounce back for another rally, but we will not be surprised to see a return to more pullbacks, with greater magnitudes, than has been the case in recent years. The return of the periodic 10% correction, something we have not seen since 2011, is likelier to happen if something else comes back to the market that has been AWOL for a while: volatility.
Been Away For So Long
The above chart is something we have shared before with our Market Flash community: the volatility gap that has persisted almost without pause for the past two years. The CBOE VIX index, fondly referred to as the “fear gauge” by Street pros, had an average closing price of 14.2 in 2013 versus the long term average of 20.2 going back to the index’s inception in 1990 (a higher VIX price means more volatility). Even 2012, a relatively tame year with no 10%-plus corrections, had an average VIX level of 17.8. Those spectacular returns of 2013 came with relatively little risk.
In finance, as in other walks of life, what goes down eventually comes back up. Volatility will return; the question is whether that return is imminent or whether U.S. equities still have a couple big rallies left in them. We are increasingly of the opinion that the return will be sooner rather than later.
(Macro) Event Planning
One thing seems evident: we’re in one of those event-driven environments where meta-narratives rise organically out of the swamp of macroeconomic data points, corporate earnings releases and global goings-on in places like China, Turkey and Brazil. The meta-narrative of late has been decidedly negative. Emerging markets currency crises have prolonged the pain for investors with long exposure to what are looking less and less like the “growth engines” of several years ago. That in turn has concentrated attention on the greatest growth engine of all, China. Concerns have bubbled under the surface for several years now about whether the world’s second largest economy can pull off the feat of defusing a potential credit bubble while rebalancing its growth away from increasingly speculative investment towards a healthier level of domestic consumption. The numbers coming out of China always must be taken with a measure of skepticism; nonetheless, a China-centered shock would have the potential to scorch a wide swath of asset class terrain.
Still Not Cheap
Meanwhile, the latest pullback has knocked about a point off the S&P 500’s next twelve months (NTM) P/E ratio, as seen below. But a pullback of a bit less than 6% doesn’t make for a screaming bargain when it comes on the back of a year of 30%-plus gains. At 14.4x, the NTM P/E is still above its 10-year average of 13.9x.
Indeed, the market’s recent success may amplify the negative tone of the prevailing narrative. With few investors expecting equities to deliver anything as spectacular as last year’s gains – especially the record-breaking risk-adjusted returns – and corporate earnings doing little more than to (mostly) beat downward-revised expectations, there may be an enthusiasm gap between the Pollyannas on one side and the Cassandras on the other.
So where does our -5.76% pullback go from here? Well, the S&P 500 closed 1.2% higher on Thursday, its biggest gain for the year to date. What that says about tomorrow, or next week, is anybody’s guess. But whether our scribes record -5.76% in the MVCM Pullback Annals or not, we are prepared for a volatile ride in 2014.