EAST CAPITAL COMMENT: Confessions of an emerging market optimist

Arguably it is not very easy to be an emerging market (EM) optimist these days. It seems like almost everything and everyone is against the group of markets that were once the darlings of investors. Tapering is the most obvious cause for pessimism and is the most important factor behind the sharp EM equity and currency sell-off during the second half of January.

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But there are some other factors at play as well. The fact that economic growth decelerated and was revised down by most analysts for most of last year did not help. That, combined with concerns about longer term economic and political sustainability in a number of large emerging markets, resulted in weak stock markets during a year when developed markets rallied to new all-time highs.

But perhaps the biggest reason optimists like myself are struggling right now is because the policy response has been weak, late or in some cases even counterproductive. There was a delayed response to the currency sell-off in much of the emerging world, which resulted in bigger depreciations and larger rate hikes than would have been necessary if central banks would have acted earlier and more decisively. Structurally, the reform momentum has slowed down considerably. The European Bank for Reconstruction and Development (EBRD) measures this on a yearly basis in Eastern Europe and pointed out in its latest assessment that the number of country reform downgrades outnumbered the upgrades for the first time ever last year.

Despite the negatives, things are not necessarily as bad as they might seem. Sentiment tends to be reactive and the fundamentals are not all that bad – at least not if one has a selective approach to investments. We have been asking a lot of clients lately if they are fundamentalists or sentimentalists. To the fundamentalists we argued that there are still a lot of attractive macro and market fundamentals within the EM space, although not as a general rule. Russia, for instance, looks very resilient to tapering from a fundamental standpoint due to its budget and current account surpluses, combined with low public debt and large currency reserves. China also looks pretty good as well, whereas Turkey and, to a lesser extent, Brazil, India, South Africa are more vulnerable.

To the sentimentalists we have tried to encourage them to think about how quickly things can change. A fellow EM optimist, Daniel Salter at Renaissance Capital, pointed out that there was a very negative consensus on US equities three years ago, the Eurozone two years ago and Japan one year ago – and look what happened to those markets. The recent EM sell-off has been sharp, indiscriminate and most likely exaggerated. There is reason to believe the sentiment on the EMs will reverse. The obvious question is when. My guess is that it will happen once the cyclical recovery is confirmed and analysts start to revise up their now very gloomy outlook. This brings us to the last point.

Most economists were spectacularly wrong in their growth forecasts for some of the largest emerging economies last year. At the beginning of 2013, the consensus was that the Russian economy would grow more than 50% faster than it actually did. The forecast for Brazil missed by almost 40% and it was off by a third for India and South Africa. Ironically, the forecasts were most accurate for the economy that most were worried about, China, where consensus only missed by a tiny 5%.

When you make such a big mistake, you are obviously very reluctant to make the same mistake again. So consensus now has relatively conservative forecasts for Brazil, Russia and South Africa. This may be a mistake since the cyclical recovery is likely to be considerable on the back of stronger external demand and low base effect. The recent currency depreciation should only make exports more competitive.  The potential for positive surprises may be biggest in Russia given its strong macro resilience to tapering, buoyant consumption and expected turnaround in inventory cycle (some economist claim destocking alone shaved off 1.8pp of GDP growth last year).

This does not mean that one should revise up the longer term potential growth forecasts for these economies, it just implies that sentiment could be wrong and that growth may prove to be a positive surprise this year. Put another way, one can remain concerned about the structural/longer-term outlook and at the same time believe that short-term growth will be positive.

Finally, the importance of distinguishing between opportunities in the short and long term as well as acknowledging the divergence within the EM space suggest that we should move away from general assessments of the asset class and, if possible, abandon the fad for catchy acronyms that tend to group countries together for the wrong reasons.