Cautious optimism on emerging markets

OVER the past three years, emerging-market assets have been market laggards, weighed down by concerns over the Chinese economy, geopolitical tensions and the United States' phased withdrawal of quantitative easing measures. But investor sentiment seems to be warming after the end of the first quarter. Data from EPFR Global points to a revival of interest among institutional investors even though retail redemptions continue to outpace inflows. The first quarter's overall picture, however, isn't pretty. Net redemptions out of emerging market equity funds exceeded US$41 billion compared with net inflows in the same period in 2013 of nearly US$30 billion. Over the past 12 months to April, the US market has returned 19 per cent based on the S&P500 compared with minus 0.11 per cent for emerging-market equities. This year, however, developed and emerging equities are treading water.

To be sure, emerging market valuations are attractive. Based on the price/earnings multiples, they have been trading at a discount of more than 30 per cent compared with mature markets in recent weeks. But most strategists remain cautious. Political risk is a concern as a number of countries go to the polls this year, including Brazil, Indonesia and India. Economic indicators remain mixed. China's PMI edged up slightly in March, but not enough to dispel concerns about an impact of a slowdown on the rest of the region. Elsewhere, the Institute of International Finance highlights a significant rise in the debt load of emerging-market corporates, from just over 55 per cent of GDP in 2007 to around 80 per cent currently. China's corporate debt to GDP ratio is now the highest in the world, it says, at 145 per cent, while South Korea's is at 110 per cent. It notes that debt-loaded emerging corporates are ill-equipped to deal with the challenges of slower growth and rising interest rates.

Investors are often urged to be contrarian, but in the current circumstances it may be prudent to wait or drip-feed one's investment into the region. Capital outflows - the bane of emerging market assets - are yet to run their course, and today's attractive valuations could get even more compelling in the near term. Yet another risk is higher interest rates. A simulation by the International Monetary Fund, which posited a 25 per cent rise in borrowing costs and a 25 per cent drop in company earnings in 15 countries, found that emerging market companies accounting for 35 per cent of outstanding debt could find debt servicing a challenge.