The emerging markets (EMs) equity asset class has had another difficult year in 2014. Having declined by 1.82 per cent (gross returns in dollars), EM equities have once again underperformed the MSCI ACWI (All Country World Index), which rose by 4.71 per cent in 2014. This is the third year of the last four (the only exception was 2012) in which EM equities have underperformed the world equity index. Over the last three years, the EM index has risen by 4.41 per cent annualised compared with 14.72 per cent for the world index (all in dollars), and even over five years the performance for EM equities is only 2.11 per cent annualised compared with 9.74 per cent for global stocks. Looking at data stretching back to mid-1994, EM equities have delivered returns of 5.85 per cent annualised compared with 7.26 per cent for global. The underperformance seems to be persistent.
Unfortunately, despite the poor recent performance of EM stocks, there seems little respite in sight even in 2015. Given the view that we are in an environment with a strong dollar and weak commodities, it seems difficult for EM equities to do well even in 2015. EM stocks have underperformed two-thirds of the time when the dollar trade-weighted index has appreciated. A strong dollar is one of the clearest calls for 2015, and will be a huge headwind for EM stock performance. Balance sheet leverage in dollars among EM companies has surged, and may be the Achilles heel of the asset class as currency mismatches destroy balance sheets. Many smart macro funds think that we are only about half-way through the dollar-strengthening trade, ensuring continued pressure on EM stocks for the foreseeable future.
EM equities have also traded very much in sync with global commodities. If one were to plot GEM (global emerging markets) relative performance to MSCI World versus Commodity Research Bureau industrial commodity prices, they move almost in lockstep. The GEM relative performance has also very closely tracked the relative performance of the mining sector. Given that commodity prices are in deep stress – akin to a bubble bursting – with the commodity super-cycle almost surely over, this also does not bode well for EM equity performance.
The GEMs also now seem to have become more rate-sensitive than cycle-sensitive. EM equities used to move in line with the performance of cyclicals versus defensives – doing well whenever cyclicals had the upper hand. In the last two years, this has changed and EM equities seem more sensitive to rates than gross domestic product. If 2015 does turn out to be the year when the United States Federal Reserve finally hikes and begins to normalise rates, that once again could pose a challenge for EM equities.
Even on a valuation basis, once one adjusts for sectoral composition, EM equities are not as cheap as the high-level numbers seem to show. EM stocks are trading at only a three-per-cent premium to their long-term average vis-à-vis developed world equities on sector-adjusted price-earning multiples (according to Credit Suisse). This is because almost all that is cheap in the EMs is China, Russia and Korea along with the banks and resources companies. It is tough to make the argument that the EM asset class is so cheap that there is no more relative downside left. Nor are funds significantly underweight on EMs.
Given that India is a consensus and large overweight for most GEM and regional managers, unless the EM asset class does well and gets large inflows, it is difficult to see where new EM money for India will come from. We received large inflows in the last three years despite weak EM performance as India moved from a consensus underweight to a large overweight for most EM and regional money managers. This shift in relative weights is done, and we received a disproportionate share of EM inflows while it was ongoing. There is really no scope for a further rise in the India overweight among these managers.
If EM equities continue to do poorly, and we see outflows from the asset class, given relative overweight and strong performance, India is bound to be a source of funds in any redemption-linked fund raise. Flows into India from here onwards are almost entirely linked to flows into the EM asset class, the short-term prospects for which do not look good. India has now started attracting global money independent of the EM pool, and while these flows de-risk our EM dependence, they will take time to pick up speed.
I make these comments because there seems to be an implicit assumption among market participants that India is on the verge of getting huge equity inflows from foreign institutional investors (FIIs). I have heard figures of $ 25 billion-$ 30 billion being casually discussed. Time for a reality check. Even in 2014, with the positive shock of the elections and the oil price collapse, we received about $ 16 billion compared with more than $ 20 billion in 2013. The equity flows in 2015 will most likely be lower still.
Market players have to stop being obsessed about FIIs and start tracking domestic equity flows, for that is where the incremental capital will come from. 2015 may mark an important transition wherein domestic flows become larger and more relevant than global flows. After three years of selling $ 10 billion of equity every year, local investors can and need to buy $ 12 billion-$ 15 billion a year.
This transition to domestic flows is critical as the need for equity capital in India is very large. There are three large buckets of equity issuers: the government divestment programme (at least $ 10 billion a year), public sector banks (another $ 5 billion-$ 10 billion a year) and the need for balance sheet repair among corporate India (about $ 5 billion-$ 10 billion again). This is without even considering the needs for the infrastructure public-private-partnership programme and growth capital.
Without a surge in domestic savings into financial assets, especially equities, these fund-raisings will not happen. Absent this equity supply getting absorbed, how will we fund the Budget, improve corporate creditworthiness and get back to seven-eight per cent growth?
Policymakers need to focus on raising financial savings, especially into equities. Until sentiment towards the EM asset class changes significantly, we cannot expect FIIs to absorb all the paper we need to issue. We need to find domestic buyers and immediately. We need to create our own long-term pools of domestic equity capital.
The Reserve Bank of India has already moved to a regime of positive real rates, boosting financial savings – but we need the finance ministry and the securities regulator to enable changes in tax incentives and the distribution architecture of financial products to convert financial savings into equity flows. This Budget will be key to see what steps are taken in this direction.
The writer is at Amansa Capital. These views are his own