Will foreign investors rekindle EM love?
Premium- Emerging markets, including India, have seen FII outflows after the Russia-Ukraine war began
- Concerns on crude-led inflation and widening trade deficits have made EMs unattractive
The curtains are coming down on FY22, a year the Indian equity markets put up a decent show, with Nifty50 and the Sensex rallying around 19% each despite relentless selling by foreign institutional investors (FIIs) after the Russia-Ukraine conflict started. Domestic institutional investors saved the day with their buying spree, containing a steep fall in Indian indices.
In their flight to safety, FIIs have been ruthless with India and other emerging markets (EMs). For EMs, the fallout of the Russia-Ukraine conflict will be felt in the form of supply chain disruption, widening trade deficits and soaring inflation. After-effects will vary from one country to another based on their exposure to the warring nations.
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Analysts from Nomura Singapore Ltd caution against putting all EMs in the same category. Nomura’s analysis of the economic health of 20 EMs showed that China, South Korea, India, Thailand, and the Philippines are Asian countries that have commodity-related dependency on Russia. However, these countries have relatively sound fundamentals and should benefit once commodity prices fall. On the other hand, Hungary, Romania, Turkey, and the Czech Republic fall in the vulnerable category, it said.
The geopolitical “guilt by association" stand has led to undeserved punishment for EMs, said Saira Malik, chief investment officer at Nuveen Asset Management. “The tendency to view the EM universe as monolithic ignores its exceptionally diverse nature. Variations run the gamut not only in terms of geopolitical risks, but also by economic profile, fiscal and monetary policy, balance of trade, and the role of commodities and currency regimes. Failure to consider these factors has led to broadly oversold conditions in EMs," she said in a weekly note dated 28 March.
Nuveen AMC remains constructive on EM equity markets, particularly China, where uncertainty associated with geopolitics and covid-19 containment measures might make for a bumpy road in the near term, but economic fundamentals remain intact.
If everything is expected to be well for EM equities, what will it take for FIIs to rekindle their love for this asset class? A lot would depend on how central banks of exposed nations tackle inflation and other macroeconomic consequences.
One factor that can force a turning point where capital starts flowing back from developed market to EMs is interest rate hikes.The rising risk of runaway US inflation has the country’s Federal Reserve poised to deliver aggressive, front-loaded interest rate hikes this year, pointed out the Nomura report. Nomura’s Fed forecast gives a terminal Fed funds rate of 4.00% by July 2023. “This could end the secular bull runs in the US bond and equity markets," said Nomura.
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For India, earnings growth and valuations would be the deal breakers for FIIs. Indian companies in many sectors such as paints and cements rely on crude-based derivatives, so there are concerns that FY23 corporate earnings estimates are at an increased risk of downgrades if companies fail to adequately raise prices and protect their margins. India’s price-to-earnings multiple is at a premium to many global peers. Against the backdrop of macro worries and subdued demand conditions, a higher valuation multiple discourages FIIs from being gung-ho on India.
“Foreign portfolio investors perhaps expect low returns from the market and are acting on their negative ‘expectations’ by selling aggressively. In our view, their expectation of low returns stems from the expensive valuations of the Indian market relative to history, bond yields and other major markets and rich valuations of ‘growth’ stocks," said Kotak Institutional Equities in a report on 30 March.
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