Emerging markets need a structural overhaul before they can return to favour

Tom Stevenson
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PEOPLE talk about emerging markets as if they were one homogenous group, but nothing could be further from the truth. The only thing that really links Argentina, Turkey and Indonesia is that they all look vulnerable to further volatility in their currency, bond and equity markets.

The diversity of the emerging market universe is such that no-one can even agree on the main cause of last week’s wobble. Was it the ongoing tapering of the US’s quantitative easing programme or China’s shadow banks or just plain economic mis-management?

For those countries that have relied too much on foreign investment inflows – such as Turkey – the reversal of “hot money” flows back to the perceived safety of the US is the proximate cause. For Brazil and South Africa – big commodity exporters – China’s slowdown is the main culprit. In Argentina and Venezuela, we don’t need to look much further than incompetent, populist government.

Investment cycles tend to move slowly. In the 1990s, the US led the pack on the back of the technology boom and a strong dollar. The subsequent 10 years belonged to the developing world, as the dollar fell and Americans chased returns in more exotic locations. Now that the cycle has turned again, it might be premature to think that emerging markets are going to return to favour any time soon.

One reason is that their economic model needs a radical overhaul. Exporting their way to prosperity made sense during the West’s debt-fuelled boom years. Now we are all rebuilding our balance sheets, a rebalancing towards domestic consumption, underpinned by local financing, looks preferable.

The years of easy money would have been a good time to fix the structural failings in their economies. In today’s environment, the adjustments will be harder. That means that the valuations in many developing stock markets look too punchy. They are on a par with the developed world in many cases, and that does not seem to take into account the, now much clearer, risks involved.

But I’m falling into the trap of generalising. There are pockets of real value in emerging markets. Countries that have reduced their current account deficits and developed robust local bond markets look better supported. And in some cases – China and South Korea leap out – stock markets are extremely cheap compared with the developed world.

There are some great companies in emerging markets and stock-pickers will continue to find opportunities as the wheat is thrown out with the chaff. I think China might well turn out to be one of this year’s surprises, despite the many things there are to worry about in the country – slowing growth, a property bubble, bad loans and unreliable corporate governance. On less than 10 times earnings, many of the risks are factored in already.

When I set out my Outlook for 2014 recently, I said that the US, Japan and the UK were my favoured markets, with emerging markets looking exposed to the twin squeeze of the Fed’s taper and China’s slowdown. Nothing has changed in the past few days to change that view.

Tom Stevenson is investment director at Fidelity Personal Investing.

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