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Emerging markets shares, local debt

The spike in the Chicago volatility index and US Dollar Index is an obvious headwind for emerging markets equities. The growth hit in India (do not forget my call for Sensex 15,000 in six months!), state intervention in Brazil, no PBOC monetary easing in China a brutal fall in gold and crude oil are all bearish for the emerging markets index fund, which can easily fall from its current 44 to the 38-39 range. Emerging markets are at grave risk of EPS declines, political risk, hot money outflows and valuation derating such as India can well fall as much as 15-20 per cent this year.

The MSCI Emerging Markets Index now trades at 10.2 times earnings, a 25 per cent discount to MSCI World. This metric conceals significant divergences in valuations. The Philippines trades at 18 times earnings as Asia’s most expensive stock market while South Korea trades at 8.5 times forward earnings and Russia a mere 5.6 times earnings. Indonesia and Malaysia both trade at 15 times earnings and are vulnerable to fall in commodities and political risk. It is surely significant that the MSCI Emerging Markets Index peaked on January 3, that two-thirds of index companies reported profits that missed estimates. It would not surprise me if the MSCI Emerging Markets Index falls to 940-960 if risk assets are repriced lower.

It is also significant that bellwether shares in Russia and Brazil, Gazprom and Petrobras, have tanked since Gazprom warned about a dividend cut on lower natural gas exports and Petrobras warned about a dividend cut on an earnings hits. Chinese property developers were sold aggressively in Shanghai and Hong Kong as the government targets real estate speculation. Cnooc, Sinopec, PetroChina, Chinalco and Jiangxi Copper are obviously at risk if Wall Street reprices a premature Fed QE exit.

However, as long as GDP growth remains eight per cent in China, Shanghai is not expensive at 9.8 times current earnings. Yet despite higher yuan swap rates, I doubt if the PBOC has any reason to tighten monetary policy and the anti-property speculation crusade of the Politburo is at least three years old. Shanghai is a market where value accumulation is a rational strategy. As the yen rises to 92, South Korean shares are attractive at 8.5 times forward earnings, a full standard deviation below its historic valuation range even though EPS growth could be 13 in 2013. Korea’s chaebols have built offshore manufacturing hubs and brand equity that insulate them from draconian shifts in foreign exchange rates. In any case, South Korean banks and insurers will benefit most from the inevitable Bank of Korea rate cuts and Madame Park’s first expansionary budget.

Brazil’s Bovespa has now fallen almost 10 per cent in 2013. Global investors are horrified by the Dilma Rousseff intervention in credit card, electricity and gasoline pricing. The Bovespa, dominated by Vale/Petrobras, can easily fall to 54,000. I still expect the Hang Seng to fall to 22,000 and Thailand’s SET index to dip to 1,400 before value emerges. I believe emerging market local currency bonds will outperform emerging-market dollar sovereign bonds in 2013 as well as offer higher real yields/diversification benefits to Gulf investors.