Prudential: Emerging Markets have Further to Fall

Emerging markets may have rallied year to day, but that will not continue, according to an economist at Prudential.

Speaking at a breakfast briefing on Tuesday, Leila Butt, senior economist at Prudential Portfolio Management Group said emerging markets were recovering thanks to a pause in interest rate rises by the US central bank. The Federal Reserve raised rates for the first time in seven years last December, but despite expectations of up to four rate hikes in 2016, has delayed further action.

Butt expects the US to continue on a rate hiking cycle later this year, potentially in December, which would put renewed pressures on emerging markets.

Rising Debt Levels on Emerging Markets

“Emerging markets will have a lower growth trend going forward,” Butt said, blaming rising debt levels in emerging markets over the past few years.

“Corporate debt has risen and a lot of that debt is in foreign currencies which amount to higher borrowing costs. So we are concerned that this level of corporate debt could result in systemic distress which would impact the banking sector,” Butt said.

“That could also have a knock-on effect on sovereign debt because the interlinkages between corporate bonds and sovereign debt in emerging markets tend to be much closer than in developed markets.”

China: Emerging Market Slowdown Driver

Butt believes that China, the largest economy in the world by some measures, is set to slow gradually in coming years.

“A lot of emerging markets have interlinked with China through supple chains, and with China rebalancing their economy to one which is consumption driven, those links are leading to a slowdown in global demand and global trade,” Butt explained.

According to data provided by Prudential, there are signs of weak global trades, both in value terms and volume terms.

China has one of the highest debt levels in the world at around 250% of its GDP, and there are concerns about how the nation can manage those debt levels without having a “hard landing” – a rapid slowdown in economic growth. Butt predicts that China will not return to the double-digit growth of the past, instead will slow to a more sustainable growth level of 5%.

According to Prudential’s research, Brazil, Turkey and India look most vulnerable to economic shocks due to their substantial current account imbalances.

Emerging Market Equities are Not “Compelling”

David Shairp, head of research at Prudential said emerging markets were “arguably the toughest investment call at the current time”.

He said that investors need to have compelling reasons to be in emerging markets, given the challenging fundamentals the economies are facing.

“You need to have valuations at compelling levels rather than just attractive. You need to have evidence that the economic slowdown and correction, particularly in China, has run its costs. Also you need the evidence of companies cleansing their balance sheets. In this case, we are not there yet,” Shairp said.

Equity valuations in emerging markets are currently at a 5% discount to global equities, according to data provided by Prudential. Looking at particular regions, Asia and emerging Europe look quite attractive while Latin America still looks expensive.

“To my mind Latin America is not compelling cheap compared to levels you receive in Asia, Russia and Brazil,” he said.

Source: Morningstar. Karen Kwok | 13/07/2016

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