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Emerging Market Capital Outflows: An Opportunity?

Emerging markets are likely to experience a net capital outflow for the first time since 1988. With asset prices falling, we consider if this presents an investment opportunity.

Summary

Net capital flows to emerging markets (EMs) in 2015 are forecast to be negative for the first time since 1988.

This is being driven by a slowdown in EM growth and uncertainty regarding China’s economy and policies.

Capital flows to emerging markets (EMs) have weakened sharply in recent months according to the Institute of International Finance (IIF), an affiliated organisation of the World Bank.

The IIF is projecting that flows into EMs from non-resident corporates and individuals will fall to below 2008 levels while outflows from residents are rising. The result is likely to be a net capital outflow from EMs, as a group, for the first time since 1988.

Structural problems

Unlike the 2008 crisis, the pullback from EMs has been driven primarily by internal factors, reflecting a sustained slowdown in EM growth and amplified by rising uncertainty about China’s economy and policies.

This deterioration in EM growth reflects a weakening of fundamental drivers as well as cyclical factors.

The IIF projects EM growth to reach only 3.5% in 2015 which is less than half that of 2010, and the lowest since the 2008/09 financial crisis, with only a modest revival to 4.2% projected in 2016. This is well below the average of the past ten years, notwithstanding solid growth momentum in the more mature EM economies.

The central challenge to growth is the previously successful export-oriented economic model which benefited from the reduction of trade barriers and the introduction of new technologies.

However, three factors have combined to reverse EM growth: (i) the rising importance of the less easily tradable services sector in the mature economies; (ii) the onset of population ageing in many EMs (more people dependent on the state being funded by fewer workers); and (iii) lower global demand for commodities (affecting mineral- and oil-exporting countries for example).

What’s more, the diverging monetary policies in mature markets (possible interest rate increases in the US vs quantitative easing elsewhere) could contribute to market volatility.

Delicate China

China is both a victim and a catalyst of the prevailing woes. Its growth has slowed markedly since 2011 and policymakers have struggled to advance reforms while also meeting growth targets. Fears of a rapid slowdown or even a hard landing have been increased by stock market turbulence over the summer, weakening growth indicators and the surprise “mini devaluation” of the Chinese currency in August.

The government faces a conundrum: how can it operate an increasingly open capital account (which would see further capital outflows in the current climate), while stabilising its exchange rate (which China is propping up by buying its own currency and depleting foreign reserves) and yet simultaneously easing monetary policy (making the currency weaker and thereby encouraging further capital outflows)? There are no obvious answers.

Acute pressure for some

China’s closest trading partners have been particularly badly hit by the Chinese ailments and, for some countries, recent movements in asset prices are approaching crisis dimensions.

For example, EM currencies have dropped sharply in value against the US dollar while total currency depreciation since the start of the year for countries including Brazil, Ukraine, Turkey and Colombia now exceeds the 25% threshold commonly used to identify an external crisis.

However, in general EMs have greater resilience against severe capital outflows given flexible exchange rates, higher reserve levels, and improved public sector balance sheets.

So are prices falling sufficiently to create an investment opportunity?

Are EMs undervalued?

The fall in EM equity prices has been severe as a result of both the fundamentals discussed above and the declining global appetite for EM stocks. Global mutual funds and exchange-traded funds have reduced their EM allocations by more than eight percentage points since 2010, to just 12% of investors’ portfolios in 2015.

A range of valuation metrics suggest that EM equity markets might be undervalued compared to 10-year averages. For example, in mid-September 2015 the MSCI EM equity index was trading at a price-to-book ratio of 1.3x this is less than half its peak value in 2008. In other words, every £1 of the assets represented by the Index would have cost you £2.60 in 2008 compared to only £1.30 today.

Similarly, there is the cyclically-adjusted price/earnings ratio. This provides a ratio of current stock prices to inflation-adjusted earnings over the previous ten years. In August this ratio for EMs hit its lowest level on record.

However, disappointing corporate earnings over the past four years indicate that the recent decline in asset prices is in line with the trend of lower earnings. Hence, for asset prices to recover, it is likely that the outlook for corporate earnings would need a boost, be it from rising commodities prices, stronger demand from China or mature markets, or from structural change.

So, in conclusion, while EM equity valuations are at low levels compared to past values, the near-term downside risks are high enough to keep us cautious about re-entry.

Important information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions.

The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this webpage or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this content are our in house views as at 1 October 2015 and should not be relied upon as fact and could be proved wrong.

The information contained on this webpage has been derived from sources which we consider to be reasonable and appropriate.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

Sources: Institute of International Finance, Lloyds Banking Group.

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