Emerging markets are out of favour, and so is SA

Global investors are turning away from emerging markets, SA.

It has not been a great year for emerging markets. The MSCI Emerging Markets Index, which measures equity market performance in 21 key emerging markets around the world, has declined by over 11% during the course of 2013, while the MSCI Emerging Markets Currency Index, which tracks the performance of those countries’ currencies relative to the US dollar, has fallen by over 5% since its high in early May (see chart below).

The sell-off in emerging markets (EMs) has been near-universal. The chart below shows the relative performance of several MSCI EM indices, including the overall index, and indices for Asia, Europe, the Middle-East and Africa (EMEA), Latin America, and Africa. It also includes data for the Africa index that excludes South Africa. As you can see, with the exception of the Africa index that excludes South Africa, which is flat, EM indices are down across the board: the MSCI Emerging Markets Asia Index is down 7.4%, the EMEA Index is down 15%, the Latin America Index is down 18.6%, and the Africa Index (including South Africa) is down 14.4%.

The picture isn’t much cheerier for currencies. The Brazilian real, for example, has lost 15% of its value against the US dollar since the start of the year, while the South African rand has shed around 20% of its value, as has the Indian rupee, and the Turkish lira has declined by 14%. Indeed, so bad has the currency rout been that India has called for co-ordinated interventions in currency markets by emerging market governments.

So, the question is: what gives? Why are EMs performing so poorly?

There are basically two theories. The first is that it’s Fed tapering. For the last few years, the US Federal Reserve has been pursuing a policy of quantitative easing, injecting money into markets to keep them afloat. This has meant that interest rates in the US and the rest of the developed world have been very low and as a result, rich country investors have poured money into emerging markets in pursuit of higher returns. However, the Fed is now planning to start cutting back on its support, which will raise rates in the developed world and, the theory goes, encourage rich world investors to move their money back home.

As Ed Yarendi, president and chief investment strategist of Yardeni Research, puts it, “The currencies, bonds, and stocks of EM economies have been getting clobbered … because global investors fear that the consequences of prospective Fed QE tapering will be more severe for the EMs than for developed economies.”

In a similar vein, Arjun Jayaraman of Causeway Capital Management argues that the fall in EM currencies is directly related to fears of rising interest rates in the US. Historically, he says, crises in EM currencies, such as the 1997 baht crisis, have been linked to changes in US Fed policy, and particularly to tightening in Fed rates. The current fall in EM currencies is thus in line with what we should expect during a period of Fed tightening.

However, the issue may be more complex than this. According to Patrick Zweifel, chief economist at Pictet Asset Management, Fed tapering is just a scapegoat for the current EM turmoil. Zweifel argues that the fall in EM equities and currencies is in fact the result of weaknesses within those economies. In particular, he cites a lack of economic diversity, an over-reliance on a few key sectors, a lack of financial market depth, and issues with political and financial governance as underlying drivers of the sell-off.

This interpretation is echoed by recent notes from the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD). On Wednesday, the OECD released its latest Interim Economic Assessment, which noted that while growth is accelerating in developed countries, growth in EMs is slowing markedly. The OECD says that developed economies are likely to be the engine of growth for the global economy over the next few years; given that, it’s no surprise that EM equities and currencies are under pressure. This analysis was echoed in a confidential note released by the IMF and obtained by Reuters, in which the IMF said that global growth would henceforth be driven by developed economies and warned of continuing weakness in EMs.

South Africa has certainly been affected by the general weakness in EMs. In dollar terms, South African equities have fallen about 14% this year (see the MSCI South Africa Index), mostly as a result of rand depreciation; as mentioned the rand has lost about 20% of its value since January. Looking ahead, it seems likely that South Africa, like other EMs, will continue to experience weakness in its equities and currency.

According to Richard Schellbach, equity strategist at Citi, South African equities are looking very expensive. The MSCI South Africa Index is trading at around a 13 P/E, which is fairly high – certainly higher than the 11P/E at which the MSCI Emerging Markets Index is currently trading. Thus, it looks like South African equities still have a ways to fall in dollar terms. It’s going to be rough times ahead for the currency and for financial markets.


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