Emerging Markets Not Really a Bargain

Jason Stipp: I am Jason Stipp for Morningstar. After a disappointing 2013, emerging-markets investors may wonder what's next, what's coming up in 2014, and will the volatility continue? Here to offer her insights is senior fund analyst Patty Oey who covers emerging-markets funds.

Thanks for joining me, Patty.

Patty Oey: Thank you for having me.

Stipp: A lot of investors are looking at the MSCI Emerging Markets Index, and they're thinking maybe it looks cheap now. We've had a very disappointing year, especially compared with developed markets. What's your take on that assessment of emerging-markets valuations?

Oey: I would caution against saying, overall, emerging markets are cheap, mainly for three reasons. The first reason is that in the MSCI index about 20% of the index is in China, and within China about 40% of that is in its large banks. The large banks are trading at extremely cheap valuations, and this is because there is a lot of concern about the quality of their loan books. As China implements some of these reforms there is a lot of uncertainty regarding the regulatory environment as well as the competitive environment. These banks are actually trading at record price/book and P/E multiple lows. So, there could be some value in these names, but it is going to be a very turbulent ride in the near and medium term.

Stipp: You mentioned that emerging markets, in general, are in some ways facing their own kind of new normal, something that U.S. investors have heard a lot about over the last few years, since the financial crisis. What do you mean when you say that they have their own new normal?

Oey: On some level, people are saying that emerging-markets [sector] looks cheap because it looks cheap on a P/E basis relative to its recent history. But in the past, we had two very big distortions, namely a big commodity boom and incredibly low interest rates. This new normal, we head in the opposite direction of what we had over the last decade. So, the commodity boom is over, interest rates are rising, and we are going to see less of a credit-fueled growth compared with in the past.

Stipp: In summary, would you say that investors that are hoping for the levels of growth they've seen in emerging markets might want to reset their expectations a little bit for what may come ahead?

Oey: Yes, definitely. For what it is worth Jeremy Grantham and his colleagues at GMO forecast about a 3% annual real return over the medium term. That just gives some perspective.

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Stipp: One of the things also that emerging-markets investors faced in 2013 was currency volatility, and there are probably a lot of drivers behind that. How should we be thinking about these trends and if they will persist into the next year?

Oey: Right. If you compare the index performance in U.S.-dollar terms versus local-currency terms there is actually a 600-basis-point difference. In other words because of the currency exposures, investors lost about 600 basis points. A number of countries have seen their currencies decline very sharply.

What happened first, last summer, is that the Fed started talking about tapering [its bond-buying program], and unfortunately for emerging markets, they've been part of this risk-on, risk-off trading. Once the Fed started talking about the taper, a lot of money rushed out the doors and negatively affected equity prices and currencies.

Going forward, we could see some volatility when we hear the word "taper" again.

Stipp: Aside from the Fed, which as we know has had extraordinary monetary stimulus and knock-on effects in lots of different parts of the market, some of these countries are also facing fundamental issues even within their own countries that could be affecting the currencies.

Oey: Right. The countries that have seen sharp declines in their currency include Turkey, South Africa, India, and Indonesia. Yes, what you are seeing is that fundamentals are deteriorating. They are seeing rising fiscal deficits, rising current account deficits, and rising inflation. You have those and as they try to address these issues by tightening monetary policy and rolling back some of the fiscal stimulus, that can be a weight on growth in the near term.

Stipp: Are we also facing any kind of political instability in some of these regions that could cause volatility?

Oey: Well, not necessarily political instabilities, but actually every single one of those countries they're either going to have a presidential election or a parliamentary election, so that does add a little uncertainty in the near term.

Stipp: Given that some of these areas have faced some of their own issues--and the currencies perhaps have taken a hit--do you think that there is some value there, potentially, for investors who might want to try to get in that currency when it's depressed?

Oey: Well, actually those countries, like Indonesia and South Africa, actually have a lot of good companies that are well-run with pretty good balance sheets. And particularly in South Africa, a lot of those companies have regional African exposure. In Africa, the growth rates there are pretty good. Actually the companies, the valuations are not necessarily cheap, but these currencies have fallen 10%-20%. So, if you feel that the currency is cheap, maybe there is going to be an opportunity for those long-term investors who have a stomach for volatility.

Stipp: Some of these areas are facing some of their own fundamental pressures. Are any other areas in the emerging markets doing a little bit better where you see more positive fundamentals?

Oey: Yes. Countries with pretty solid macro fundamentals include like South Korea, Taiwan, and to a lesser extent Mexico. Actually, the foreign investment community is uniformly bullish on Mexico because of the country's recent reform momentum. This is even despite the fact that the gross domestic product growth has been actually tepid lately. But another positive in Mexico's favor is the fact that its economy is actually closely tied to the U.S., and the U.S. is kind of on more stable footing.

Stipp: You mentioned Chinese banks earlier. We haven't talked as much about China, the country, and what that means for emerging-markets investors. There is a lot going on in China. How are you sizing it up from a macro level?

Oey: For investors interested in China, China is a very difficult nut. You know, the biggest companies tend to be government-owned entities. A lot of other companies operate in industries that have a lot of overcapacity. The sexy high-growth names--these are like the Internet companies and the Hong Kong gaming companies that have casinos in Macau--those companies are trading all at sky-high valuations.

Another issue that's come up more recently, like over the last year is that we're seeing the Chinese government is trying to be a little bit more protective over their domestic industries. We're actually seeing the Chinese government go after some of these multinationals. This year, we've seen them go after Big Pharma. They have gone after infant-formula companies and tech companies, such as Qualcomm. They even accused Starbucks of charging too much for coffee.

I know a lot of investors like to invest in these large multinationals, the ones that are domiciled in the U.S. or Western Europe. There is a great deal of comfort in these companies. But I want to caution that operating environment in China might be a little bit more challenging for these firms.

Stipp: There could be some headwinds for that indirect exposure that folks are trying to get?

Oey: Right.

Stipp: You mentioned that there is an IPO pipeline in China reopening. Would that offer investors another avenue to try to get exposure?

Oey: Right. The IPO pipeline is for the onshore market, which is the A-share market. Foreign investors don't really have direct access, but overall China is trying to open the doors to let more foreign investors in.

The IPO pipeline was closed for about 14 months. They are going to reopen it early next year, and they've also changed the policies. In the past, companies were approved by government officials to have an IPO, and that system favored some of the government-owned companies.

Now, the banks managing the IPOs are going to follow a U.S.-registration-like process where investor demand will determine pricing. This, combined with letting more international investors into the A-share market, should allow investors to have more choices in China.

Stipp: A lot of moving parts in emerging markets. Unfortunately, it doesn't make a blanket statement easy about over or undervalued, but certainly a lot for investors to think about.

Thanks for joining me, Patty.

Oey: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.