Thursday 21 March 2013

Have Emerging Equities been the victims of currency wars?

"Truth is confirmed by inspection and delay; falsehood by haste and uncertainty."

Many pundits are starting to make comments on the relative underperformance of Emerging Markets equities with weakening inflows as reported by Bank of America Merrill Lynch, in their recent Flow Show from the 14th of March entitled - Equities on course for $400bn inflows this year:

"Record inflows of $2.0bn to Japan equity funds as investors continue to pile into the reflation trade. $0.5bn outflows from EM equity funds; investor sentiment toward EM starting to fade (Chart 2) after underperforming developed markets by 770bps since Dec'12"

When one looks at the relative performance of the MSCI World versus MSCI Emerging, one can easily see EM equities have been clearly lagging. Emerging markets (MXEF) have underperformed developed markets (MXWO) by 10% and the SPX by 14% YTD.  - source Bloomberg:
The ratio between both continues falling and is now at 0.7156, lower than in 2012.

As indicated by Stefan Wagstyl in the Financial Times, on the 20th of March 2013 - Emerging Markets lag behind:
"While world equity markets have generally had a good run in the first quarter of 2013, there is one conspicuous laggard – emerging markets. Developed market bourses are up 6.6 per cent on the three months but their emerging market cousins are down 3 per cent – and that is despite the sustained strength in emerging market bonds and money markets in emerging economies. Admittedly, a few emerging market bourses have done well, with Thailand climbing 11 per cent in local currency terms and Dubai 17 per cent. But Japan easily beats them with a 20 per cent gain and the huge US stock market is up 9 per cent. This is not what was supposed to happen – in the long term, emerging markets should see faster growth in economic output and in stock market capitalisation. So what is going on?" - source Financial Times.

Indeed, what is going on, we wonder? Could it be the impact from currency wars and Japan being one of the culprits?

Back in February we discussed the recent surge in the Brazilian real versus the US dollar marking somewhat the return of the Japanese Double-Decker" funds. But, today the Brazilian Real weakened to 2 per dollar for the first time since January! - source Bloomberg:
As indicated today in the Bloomberg article written by Gabrielle Coppola and Josue Leonel - Brazil Real Weakens to 2 Per Dollar for First Time Since January:
"The level of 2 per dollar was last crossed in January, when the central bank intervened to strengthen the currency as inflation accelerated. Brazil had foreign currency outflows of $990 million in the week through March 15, the central bank reported yesterday. The currency has lost 1.8 percent in five days, the worst performance among major currencies tracked by Bloomberg, The real has pared its gain this year to 2.9 percent.
The central bank has swung between selling currency swaps to prevent the real from falling too quickly and offering reverse currency swaps to protect exporters by preventing excessive gains. The real closed at a 10-month high of 1.9442 per dollar on March 8 before the central bank intervened on March 11 to weaken it." - source Bloomberg.

Japan's performance easily comes on top of Emerging Markets with a 20% gain while the US stock market is up 9% so far.

It appears to us that the "rise of the Kagemusha" we mused about couple of days ago, could indeed be the culprit for Emerging Market equities woes - reverse Itraxx Japan (credit risk perception has been receding), USD/JPY and Nikkei index, bottom graph Nikkei volatility - source Bloomberg:

Is valuation a concern for Emerging Markets equities?
As indicated by BNP Paribas 2013 Global Equity and Derivative Strategy outlook published on the 21st of March not really:

Emerging Equities have indeed been the victims of currency wars and "Abenomics:

"For some countries, the major equity indices can be much more heavily affected by foreign earnings than by domestic earnings." - source BNP Paribas

"The decline of the JPY is negative for emerging markets, obviously more for those in Asia, putting pressure on emerging company market shares for exported goods and leading to cuts in investments in Asian countries by Japanese companies." - source BNP Paribas

One thing for sure, Mario Draghi, our "Generous Gambler" and his "whatever it takes". is not alone anymore Kuroda, who officially started yesterday at the Bank of Japan, has pledged as well to do "whatever it takes" to end deflation.

On a final note, looking at the recent appetite in the UK for the construction sector (with the latest guarantee for mortgage borrowers), France (latest construction plans) and Japan's numerous public spending plans over the years, we thought this chart from BNP Paribas from their Back To the Future note on Japan from the 18th of February would entertain you, as it displays the contribution of public spending to nominal growth in Japan over the years from 1981 onwards:

If Mr Kuroda is indeed serious about "reflating" in this on-going currency wars, the "rise of the Kagemusha", no doubt, represents a serious headwind for some Emerging Markets in general and their equities in particular.

"At times it is folly to hasten at other times, to delay. The wise do everything in its proper time."

Stay tuned!

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