Analysis: After brief hiatus, emerging markets are back

By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) – The exodus of investors from emerging market equities that began late last year is reversing, in part due to the prospects for higher interest rates in developed economies and partly due to them becoming cheaper.

Moves to date reflect a classic rotation by investors back into a long-term bull play that had become overbought. While still tentative, they may be a precursor for a larger embrace of high-growth emerging markets later in the quarter.

Emerging market equities were among the hottest investor plays for much of 2009 and 2010, with MSCI’s benchmark index for the sector rising nearly 150 percent from March 2009 until mid-January this year.

Until recently, however, many investors had switched out of the sector, believing it to be overbought and at a disadvantage to resurgent developed markets, particularly the United States. The index was in the red for most of the first quarter.

This has changed dramatically in the space of a week or so. The index has gained around 10 percent since hitting a post-Japanese earthquake low on March 17. It is now up more than 3.6 percent for the year to date.

Developed market stocks have underperformed, rising about 7 percent since March 17, although they remain the better bet for the year to date, up more than 5 percent.

It is not just market movements that suggest some kind of return is underway.

EPFR Global noted that emerging market equity funds it tracked ended the first quarter with their highest weekly inflow, a net $2.6 billion, since the first week of January.

This contrasted with a net 24.5 billion being pulled out in the quarter for a whole.

U.S. financial services firm State Street, meanwhile, sees increasing moves toward emerging market equities and currencies in the multi-trillion dollar portfolios it keeps as custodian.

“Flows into certain high-beta currencies — namely the IDR (Indonesia), KRW (Korea), MXN (Mexico) and ZAR (South Africa) — have firmed, while the past month has seen cross-border equity flows into EM once again outpace developed markets,” it said.

CHANGING LANDSCAPE

Expected rate rises from the European Central Bank starting this week and the likelihood that the U.S. Federal Reserve will not extend ultra-loose monetary policy have contributed to this change.

Part of this year’s earlier rotation was based on assumptions that monetary policy designed to boost economies in developed economies would remain advantageous while higher rates designed to cool growth in emerging markets were to be expected.

That advantage has now dissipated.

“We saw food price inflation driving emerging monetary policy, while nobody expected the ECB and Fed to move,” said Maarten-Jan Bakkum, emerging equity strategist at ING Asset Management.

“Now that has changed completely. Emerging market central banks are probably close to done.”

China raised interest rates for the second time this year on Tuesday but economists say it is well into its tightening cycle.

Goldman Sachs, which predicted emerging markets sliding in popularity in the first half of this year before picking up again in the second, suggested that it may be time to switch already, although it prefers developed stocks with emerging exposure.

“After a few months of underperformance, we believe that EM-exposed stocks should start outperforming again. The growth/inflation outlook is improving in EM while developed markets, especially in Europe, are likely to see an acceleration in the pace of tightening,” it said in a note.

EARLY DAYS

Monetary policy is not the only driver for emerging markets, of course. Their hiatus from the investment landscape over the first quarter or so has made them cheaper.

I/B/E/S data shows the 12-month forward price to earnings ratio for emerging market stocks at 10.8, compared with 11.6 back in November.

Developed market stocks, meanwhile, have stayed at around 12.1, which means a valuation gap has opened up.

Some firms have been taking advantage of this as the flow data shows.

Many of the moves to date, however, appear to be investors shifting their recent underweight positions into more neutral exposure.

Credit Suisse has done just that and is eyeing the future for emerging market gains to accelerate.

The underlying appeal of fast growing emerging markets — primarily a shift from West to East — remains a strategic play even if there is the occasional short-term tactical setback.

Explaining his company’s recent swing away from emerging market stocks and then return, Lothar Mentel, chief investment officer of Octopus Investments, said:

“We did not think that the overall massive growth story had gone away. It was just a little bit over-stretched.”

(Additional reporting and graphics by Scott Barber, editing by Mike Peacock)

Analysis: After brief hiatus, emerging markets are back