What Next For Emerging Markets?

2013 Was an “annus horribilies” for major emerging markets once the Bernanke Fed signaled its intention to “taper” its asset purchase programme and decelerate the growth of the central bank’s $4 trillion balance sheet.

The subsequent rise in the 10-year US Treasury note yield to three per cent coincided with free falls in emerging market currencies such as the Turkish Lira, Indonesian Rupiah, Brazilia Real, Indian Rupee and South African Rand.

A fall in US interest rates, rallies in precious and industrial metals, a Chinese fiscal and monetary stimulus, the decisive election win of the pro-reform BJP in India and carry trade inflows into high yield emerging market countries have ended the mass exodus from the asset class, though geopolitical risks remain elevated.

Emerging markets have underperformed the developed markets of the US, Japan and Europe by a shocking 25 per cent in 2013, though their underperformance began in 2011 when their earnings and economic growth cycles began to slow with China’s falling appetite for commodities.

US monetary policies, China, currency trends, volatility, earnings momentum, geopolitics and tactical allocations will define the performance of emerging markets in the next year.

The Yellen Fed’s dovish monetary policy preludes a major rise in the US Dollar even as the Bank of Japan, People’s Bank of China and the ECB continue easy money policies, a positive macro backdrop for emerging markets.

With Wall Street at 17 times earnings and Europe’s recovery from recession fully priced in at 14 times earnings on the Euro Stoxx 600 Index, US and European pension funds are underweight emerging markets equities, with their attractive valuation discounts.

India’s Sensex rose 20 per cent even before the ruling party’s humiliating defeat to the pro-business, pro-reform BJP.

While Modi’s first Union Budget led to an almost 1000 point Sensex fall as investors were disappointed by the failure to roll back subsidies or fiscal deficit target, India offers the most attractive earnings growth (17–18 per cent) in any major Asian market even though the Sensex is no longer cheap at 18.7 times earnings.

Since the BJP government will focus on domestic consumption, Indian auto, cement and IT services firms will outperform. I expect a 23500–27000 Sensex range in the next twelve months.

Meanwhile, Indonesia has risen 20 per cent in 2014 with a seven per cent rise in the Rupiah against the US Dollar as central bank reserves rose to $100 billion and offshore capital surged into domestic equities and debt on the expectation of a Presidential election bid by Jakarta Governor Joko Widodo.

However, the election was a disappointment as both presidential candidates claimed victory. Indonesia has a history of political violence – the military coup against Sukarno, the invasion of East Timor, the insurrections in Aceh. It is prudent to avoid Indonesia for now.

The free fall in Arabtec triggered a significant correction in the Dubai Financial Market (DFM) in June 2014, amplified by margin call selling, pre- summer/Ramadan profit taking, the escalation of the Iraqi sectarian civil war and concern about earnings results.

Emaar Properties’ sale of 25 per cent of its shopping mall and retail business in an IPO will be a seminal event in the UAE stock market this autumn. Emaar’s land bank in the UAE, the prospect of a post IPO special dividend, retail’s strategic importance to the Dubai economy (20 per cent of GDP) and a valuation rerating based on its new hybrid developer/REIT model makes me optimistic on its shares.

I believe the value zone in Emaar is Dhs8 or 16 times forward earnings. Union Nation Bank (UNB) is the cheapest major bank listed in the UAE. UNB trades at eight times earnings at a time of rising loan growth and falling provisions in the UAE. UNB can well offer 15 per cent earnings growth and rising dividends in the next three years as it has a Basel Tier I capital ratio of 19 per cent, which means potential to leverage the balance sheet.