Monthly Market Report - October 2014

1st October 2014

With commentary from David Stevenson

As the S&P 500 benchmark index pushes through the psychologically important 2000 barrier, investors have restarted a debate that started earlier in the year - are markets turning into a bubble or is there even better news to come?

If the bears are wrong - and the bulls make a persuasive case - we could see sentiment improve to the one asset class that has had a very tough few years indeed, namely emerging markets. Although we've had a small rally in the last few months, most equities from places like India and China are still way off their peaks. In China for instance although the Shanghai A share market is up 12.5% year to date, it is still down 60% from its 2007 high. It is also the cheapest market in Asia, at an average price/earnings ratio of 9.6 (half of its 10-year average).

Are investors about to take advantage of this 'value' opportunity?

One interesting way of potentially addressing this question is to accept that emerging markets equities are different - rather than exclusively focus on questions of value, we should maybe accept that sentiment is important as is the flow of liquid funds between different nations.

This line of analysis is taken by an excellent research firm called Cross Border Capital. Their analysis of global liquidity trends is hugely compelling as a possible indicator for future asset class returns - much of their most recent work has been focused on emerging markets. This firm argues that emerging market equities appear to have been stuck in a downward turbulent phase for much of the last few years - private sector liquidity "is stuck near rock-bottom levels, both in absolute terms and relative to the US. This weak liquidity data also implies that EM profits may still suffer a significant near-term recession". Lurking behind this difficult macro environment is China - "Chinese Liquidity is noticeably sub-par with no indication yet that the PBoC (Central Bank) is altering its moderately tight stance (48.9). The Chinese Liquidity level is consistent with sub-5% real GDP growth. This could be a ‘hard economic landing’".

Yet Cross Border Capital has recently observed that emerging markets may be near a key turning point - with some of their key indicators implying a bottoming out of key liquidity measures.

So, given these positive numbers, what's Cross Border Capital's current prognosis? "We still have some issues with EM. Foremost is the quality of liquidity inflows. Behind the rise in our EM sub-index is expanding Central Bank liquidity. Private sector liquidity remains weak and there are no signs of any pick-up in cross-border inflows. Moreover, forex reserve growth (ex-China) is modest and, in our view, EM currencies still look vulnerable, notably when the US Fed begins to tighten more aggressively...Overall, we feel it is still too early for aggressive EM investment. Liquidity remains tight, the Chinese economy is uncertain and EM currencies look vulnerable to further weakness on a 6-12 month view".

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