Ichiro Suzuki
Emerging markets are grossly undervalued compared to the U.S. equity markets, says Bank of America. EMs have not been this undervalued vs the S&P500 since the turn of the 21st century, when the advent of the Internet and rising productivity in the U.S. economy let its markets soar. Over half a century ago, at the beginning of the 1970s, EMs were also distinctly undervalued following an era of the apex of the U.S. economy’s might as opposed to the rest of the world.
On both occasions, EMs rebounded strongly relative to the U.S. In the 1970s, commodity prices, notably crude oil prices, surged, driving economies that thrived on exporting commodities. Lax fiscal policies in the U.S., as represented by the Vietnam War and the rise of welfare, pressured prices higher, thus creating an upward pressure on commodity prices. The rise of a cartel among crude oil producing countries, the OPEC to be specific, contributed to sharply higher crude prices, too. Finally, the Iranian revolution in 1979 darkened the outlook of crude oil supply, pushing their prices even higher.
In the early years of the 21st century, the world also witnessed spectacular rises of commodities. The boom’s catalyst was China’s entry into the WTO that drove the country’s export-driven growth. Exponential growth in China let demand for commodities surge. A wasteful fashion of China’s commodities consumption fueled their prices to higher levels.
The biggest emerging market rally ever, however, was unrelated to commodities. It took place in the ten-year period that began in the mid-1980s. Latin America was in the doldrums back then under the weight of debts, as crude oil prices collapsed after a boom in the 1970s. The oil-importing West began to learn how to consume energy more efficiently. Fed chairman Paul Volcker’s draconian monetary policy to kill the inflation hit commodities in general hard. It was the rise of the Asian Tigers that led emerging markets. The rally proved to be more powerful than the one on the rise of China some twenty years later. The Plaza Accord in September 1985 engineered the Japanese yen’s surge against the U.S. dollar. By that time, Corporate Japan was already shifting their manufacturing facilities to other counties in Asia in an attempt to climb the ladder of value chains. The yen’s super normal appreciation added a very strong momentum to that trend. An industrial policy laid out by dictator Park Chunghee was beginning to show its result. South Korea was gaining strength in shipbuilding, steel production by then and moving into car and electronics manufacturing and then was moving into semiconductors. “The 21st century belongs to Asia” everyone thought. At the outset of the super rally, EMs were very inexpensive, but the asset class could be even more undervalued today after years of U.S. equities’ dominance.
If history is any guide, there are reasonable chances that emerging markets post noticeable performances in the coming years, but for what reasons do they do it? Asia no longer delivers dazzling economic growth rates even if India continues to grow faster than anyone. The markets are recently dismayed at marked deceleration in the region. Disillusionment with slower growth in Asia, notably in China, however, may have already run far enough, setting a stage for a strong rebound. Every EMs rally started amid a hopeless outlook. Japan delivered strong performances over the last dozen years, too, amid rampant pessimism. Japan’s surge, however, was triggered by dramatic policy shifts both on the monetary and fiscal fronts that had improved the country’s long-term growth outlook. At present, it seems highly unlikely that wholesale policy changes come out of the regime under Xi Jinping because he has been relentlessly expanding the Chinese state’s role in the economy ever since he rose to the helm.
India is set to become the third largest economy in a few years, eclipsing Japan and Germany. Though it is the fastest growing economy, India is growing at ‘only’ 7%’ a great deal more modest than spectacular growth rates well in excess of 10% that China had posted in its heyday. Chances are that India alone is not capable of carrying the emerging market world in a way China did in the first decade of this century.
This leaves commodity prices’ spike caused by some macro economic factors as a most likely potential driver of emerging markets. The Fed may have already gone far enough in its aggressive monetary, sucking international liquidity into its land. Unwinding of such a policy would almost certainly drive assets outside the U.S. and may create surprise winners. The currently depressed state of EM assets are presenting an opportunity for a sharp turnaround. That said, there might be a catch. An aggressive tight monetary policy often ends in tears, pushing the economy into a recession, and a banking crisis in the worst case. EMs will have no chance in this event, and could shine only in a relatively sanguine scenario of soft landing of the U.S. economy.
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