Emerging Markets: Undervalued or Value Trap?

Stocks Keep Rising

Equity markets rose for the fourth straight week, as investors appeared pleased with the way earnings season is unfolding. For the week, the S&P 500 rose 0.7% while the Dow Jones Industrial Average gained 0.6%. The Barclays Aggregate Bond Index increased in two consecutive weeks for the first time since April.

Economic data was generally encouraging last week, as the manufacturing sector showed signs of recovery. However, two high profile indicators also disappointed.

On Monday, retail sales disappointed after coming in at 0.4% for June. Consensus expected a 0.8% increase. More troubling was the underlying data, which indicated that retail spending actually contracted after accounting for the effects of automobile and gasoline sales. However, some economists noted that poor weather during the month may have impacted the figures.

Housing starts fell sharply in June to an annualized pace of 836,000. This was well short of expectations of a 951,000 reading. Since peaking out at over 1 million starts annualized in March, the series has softened in the past three months.

Three separate measures of manufacturing indicated a sector on the mend, and bodes well for the ISM manufacturing index due to be released later this month.

The first was the Empire Manufacturing Survey, a regional Fed index that measures activity in the New York area. The index improved to 9.46, a modest gain from June but sharply higher than economists’ estimates. Strength in the index was found in shipments and employment, as well as producers’ six-month outlooks. New orders did weaken, however, which is typically a negative indicator of forward momentum.

The second major regional Fed index exhibited similar strength, as the Philadelphia Fed Survey spiked to 19.8. This, too, was well above expectations and represented a 7.3 gain from the prior month. The index was in negative territory as recently as May, but has since rebounded as new orders and business activity improved.

Finally, industrial production expanded by 0.3% in the quarter, slightly ahead of consensus estimates. The manufacturing portion of the indicator also increased 0.3%, partly boosted by motor vehicles. The utilities and mining components of industrial production slipped 0.1% and expanded 0.8%, respectively.

Manufacturing is showing some signs of life following a period of prolonged weakness, as evidenced by the ISM manufacturing index slipping in and out of contractionary territory in recent months. With housing already showing signs of significant momentum, the return of manufacturing growth would provide an additional boost to the US economy.

Emerging Markets: Undervalued or Value Trap?

In the first quarter, we explored the divergence of emerging market equities from the US. We noted that a combination of factors likely drove the 12% performance differential, including investor risk appetites, inflationary pressures in developing markets, and reduced commodity price expectations.

In the second quarter, this phenomenon deepened as emerging market stocks lost 8% - again, well short of the return witnessed in US markets. This represented another double-digit return disparity, and leaves the EM index trailing US blue chips by 23% year-to-date. This is the worst performance differential through the first six months of a year since 1998, when developing markets were gripped by the Asian financial crisis.

Performance through mid-year leaves the MSCI Emerging Markets Index trading at a price-to-earnings multiple of 11.8x, well behind the US valuation of 16.6x. While developing markets typically trade below developed ones for geopolitical and corporate governance reasons, the discount to historical spread is much larger for EM than the US. Market allocators from Research Affiliates to GMO are seeing increased value in this asset class, and have shifted their portfolios accordingly.

The reasons for emerging market underperformance have seemingly evolved since the first quarter. While China has always been the linchpin that determined the fate of the broader group, the country’s economic health received far greater emphasis during the quarter. Despite idiosyncratic situations such as populist turmoil in Turkey and Egypt and rate tightening in Brazil, China dominated EM-related discussions and guided sentiment lower on the economic bloc.

Concerns about China’s economic state intensified during the period, particularly in light of stress in the country’s inter-bank lending market. Overnight rates spiked in June as the country’s central bank, the People’s Bank of China (PBOC), stunningly refused to step in and provide liquidity to the market. Rate measures such as the Shanghai Interbank Overnight Rate (SHIBOR) peaked at over 13% in response as official’s attempt to rein in risky behavior among the banking sector seemingly backfired.

The country’s attempt at reform coincides with broader-scale efforts to transform the Chinese economy from one dependent on capital investment to one driven by domestic demand. The new leaders of China, President Xi Jinping and his Prime Minister Li Keqiang, have made it clear that this goal is paramount, even if it results in some short-term turbulence. A commitment to increasing free market mechanisms within the country is seen as a major route to achieving their goal.

Turbulence is certainly occurring in the economy. Last week, a raft of important data revealed a continued slowdown in China. The country’s GDP slowed for a second consecutive quarter, to 7.5%. Meanwhile, industrial production grew 8.9% year-over-year in June, below forecasts and down from the previous month. Weakness in the rest of the world is catching up to the nation, as exports were the primary source of weakness. More surprising, however, were comments by the country’s finance minister who stated the country was hoping to achieve 7% or even 6.5% growth, below the official state target.

It appears, for the time being, it will be all things China, all the time when it comes to evaluating emerging markets. Performance through the rest of the year may depend on whether China commits the ultimate sin of failing to meet its growth targets for the year. Despite the public messaging, it seems unlikely that China’s new leadership would allow such an embarrassment to occur in their first year handling the reins, but that is hardly an investment thesis.

By most accounts, emerging markets are cheap, and cheap for a reason. Economic growth is deteriorating across those markets as a result of weak global demand. However, the magnitude of underperformance may be overdone, providing the possibility that at least a short-term bounce could be in order. Over the longer term, many companies in this index will be the direct beneficiaries of a secular rise in the middle class that is occurring across developing markets. Contrarian investors may find the recent selloff to be an attractive entry point.

The Week Ahead

There are a few important indicators to watch this week, including existing home sales, new home sales, and durable goods orders. Consumer sentiment is also on tap for Friday.

Earnings season continues to plow ahead, with major results expected from McDonald’s, Apple, AT&T, Boeing, Ford Motor, GlaxoSmithKline, and PepsiCo, among others.

On the central bank front, rate decisions are forthcoming from Hungary, Turkey, New Zealand, the Philippines, and Colombia.

The information provided is general in nature and is not intended to be, and should not be construed as, investment, legal or tax advice. Fortigent makes no warranties with regard to the information or results obtained by its use and disclaims any liability arising out of your use of, or reliance on, the information. The information is subject to change and, although based upon information that Fortigent considers reliable, is not guaranteed as to accuracy or completeness.

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