Focus on emerging markets has increased. We find that EM equity markets have not typically troughed until after current account balances have made major adjustments. At an overall P/B valuation of 2.2x, the most vulnerable EMs do not look cheap. European markets have high EM sales exposure (18% for SXXP). The underperformance of EM exposed companies has been meaningful but remains modest relative to their previous outperformance; valuations are not at a discount to the market. EM industrial and commodity exposed companies are at risk in our view.
* Further need for EM rebalancing suggests more EM weakness
Several EM current account deficits have deteriorated since the GFC, driven by rapid domestic demand growth which has in turn been fueled by unconventional monetary policy in DM. “Rebalancing” suggests domestic activity needs to cool in order for these deficits to improve. Examples from the 1990s (Mexico, Brazil, Russia, Asia) suggest that EM equities bottom only after current account balances have improved meaningfully – a process which may take vulnerable EMs several quarters to achieve.
* C/A deficit EMs’ valuations are well above historical trough levels
EMs have troughed at low valuations during previous rebalancing periods (between 0.2x and 1.6x P/B). The current environment may be less severe than historical examples, but the five EMs with most significant c/a deficits are trading at 2.2x P/B ratio, and further de-rating is probable there.
* European EM exposed companies are not yet cheap
While the underperformance of European EM exposed stocks has been significant over the past year, it is modest relative to the outperformance that preceded it, particularly between 2008 and 2010 when EMs were viewed as relative ‘safe havens’. In addition valuation is not cheap; our EMexposed basket GSSTBRIC trades at a similar P/E to the European market.
* Differentiate; remain cautious on EM industrial exposure
From a European perspective not all EM-exposed names have performed equally. The relative performance has varied depending on whether companies are facing consumers or industry: it is the industrial and commodity exposed parts of the market (GSSTBRCI) that have suffered the most. We expect this to continue as EM infrastructure and commodity capex slows. We take off our long recommendation on FTSE 100 vs. SMI; FTSE 100 is very exposed to these parts of EM. Near-term uncertainties lead us to remove our relative long on luxury goods versus food products.