EM stocks at a low ebb, but tide to turn in favour soon

ET Intelligence Group: Will the tide turn this year? That's what investors in markets as far apart as Jakarta and Jo'Burg must be hoping after they fell out of favour with several foreign funds in 2021.

But why should the tide turn, especially when the US has already announced a road map for raising rates? Analysts believe the rate tightening is already baked into current stock prices, and that there is downside support for equities beyond London, New York and Tokyo.

To be sure, the MSCI Emerging Market index dropped 5 percentage points in 2021, while developed markets (DMs) returned 20%.

The EM index has underperformed due to a 'flight to quality' in tough times that resulted in reduced exposure to risky assets and DM stocks were the preferred play of the 'reopening trade' owing to faster vaccine rollout.

Worries about EM stocks were further buffeted by the developed central bank making a hawkish plot as inflation rose to the highest in the 40 years in the US and the central bank view on northward inflation changed to 'persistent' from 'transitory' earlier. Consequently, the US dollar started firming up, and the Bloomberg Dollar spot index gained 5% in 2021 - the steepest annual gain in six years.

Traders have been taking aggressive long positions on the US dollar before borrowing costs increase. Bloomberg data showed that hedge funds' net long bets on the US dollar have risen to the highest since June 2019 on an expectation of tighter monetary policy.

This would mean dollar gains will moderate. The ICE US dollar index - a measure of the currency against six currencies - is expected to increase just over 1% by the end of the fourth quarter of 2022.

Also, historical data suggest that dollars traded firm in the six months preceding the first interest rate hike.

Finally, valuations in EMs are comforting to investors. The MSCI EM index is trading the cheapest to the US index since 2001. Valuation and earnings growth in the US should peak in the middle of 2022; this may turn investors to look at international equities to earn superior returns as EM nations begin to live with Covid-19.

In addition, a couple of EM nations have started raising interest rates; this could moderate the impact on inflation and boost real returns from emerging-market assets.

India has about 9% weightage in the EM index and on an overall basis, funds are neutral on Indian equities. Local stocks have started underperforming DM equities in the last three months as developed market's central banks took aggressive measures to tame surging inflation that resulted in an outflow of nearly $5 billion (₹38,000 crore) in the December quarter.