Emerging markets' external financing looks weaker: UBS
Emerging markets face a challenging year both in currency terms and equities, predicts Swiss bank UBS as it discusses investment options in its report, Global Outlook 2009.
In currency terms, the emerging markets started the 21st century with a bang but now it faces a challenging year, it says.
From the beginning of 2000 until early 2008, many currencies in the emerging world strengthened against the US dollar.
An important part of this currency strength reflected in the improved fundamentals in these economies, their better monetary and fiscal policies, and lower levels of government indebtedness.
In addition, that was a period of abundant global liquidity, low levels of risk aversion and a boom in commodity prices, all of which favoured the search for higher yields traditionally found in emerging markets.
However, this cycle ended just as investors became convinced that the dollar's weakened state was chronic, coupled with a thundering financial crisis and a slowing global economy. This revised that view and triggered the large-scale repatriation of capital out of less liquid markets. As a result, many emerging market currencies saw sharp selloffs in 2008, explains UBS.
For this year, UBS sees two diverging trends at work. The first is plainly less supportive of emerging market currencies: their economies will earn fewer dollars, euros and yens as their exports languish in the unfolding recessions in the US, Europe and Japan.
"Across the board, the external financing situation of the emerging markets is expected to be much weaker in 2009 than in recent years. A country's current account balance is an important indicator of support for its currency. Many economies in Eastern Europe are facing actual or possible current account deficits in 2009, as does South Africa."
In Asia, current account deficits are projected in India, Korea, Pakistan and Vietnam. Smaller deficits are projected for Brazil, Chile, Colombia, Mexico and Peru in Latin America.
In addition, UBS assumes that the ability of emerging markets to attract foreign capital, via syndicated loans, revolving credits, trade finance, IPOs, bond issuances or portfolio inflows, will remain impaired.
This, too, implies comparatively fewer US dollars circulating in emerging markets in the months ahead.
The longer that access to international capital markets remains tight in 2009, the more governments will need to draw on their foreign exchange reserves, it says.
UBS expects these countries to seek access to foreign currency funding via international financial institutions like the IMF and from government-to-government bilateral deals, such as currency swaps between central banks. In some cases, these measures are unlikely to ward off sharp currency depreciations, which could inflict further damage to the affected economies.
And since the economic downturn in expected to become worse in some emerging markets, UBS believe that emerging market currencies will be subject to periods of weakness in 2009.
"In times of crisis, Asia's many dollar-pegged currencies tend to mimic the greenback's movements more closely and for longer, which limits their potential for a rapid rebound, in our view."
For the Gulf Cooperation Council, the speculation in 2007 and early 2008 about revaluing petrodollar currencies of GCC members should be less of an issue in 2009.
"In the face of lackluster oil prices, we think the greater likelihood is that some countries will be under pressure to devalue their currencies," it says.
The second trend UBS identifies for currencies in 2009 is that the persistent and vast US current account deficit should eventually begin to weigh on the prospects of the dollar relative to the euro. This trend should help limit the depreciation of some of the major floating emerging market currencies against the dollar.
However, UBS still advises caution about increasing exposure to emerging market currencies now, at least until there is greater clarity on the prospects for a recovery in global growth.
On the other currencies, UBS sees the US dollar is at risk, whereas the euro could strengthen. "We are convinced that the US dollar's revival will be short-lived. We think that as soon as liquidity in financial markets is restored and the boost from a weaker euro is felt in Europe, the dollar will resume its depreciation path. There is a good chance that this will begin to unfold during 2009," says the report.
"Therefore, we forecast a renewed drop in the US dollar versus its G10 trading partners. We think the yen is set to weaken next year, too, when market sentiment improves and some degree of risk appetite returns," it adds.
Fundamentals speak in favour of a stronger euro, says the bank. "While we acknowledge that the recession will pose the greatest test yet to the euro since its inception, a comparison of external finance indicators suggests that Europe is better positioned than the US to cope with the difficult period ahead."
As far as equities are concerned, UBS advises not to rush into emerging markets. The valuation of emerging market equities was much improved in 2008. Based on a P/E ratio using realised earnings, emerging market equities now trade at a considerable discount to global equities compared to their 15 per cent premium a year ago.
However, considering that the global economic downturn will fully affect emerging markets with a lag, we do not find this valuation discount compelling, says the Bank.
"We see ample risk to future earnings that is not yet fully reflected in analysts' forecasts for emerging markets. And with commodity prices sharply lower, we caution against investments in the equity markets of commodity-producing nations.
"Within emerging markets, we think that investors should focus on countries with robust internal demand in 2009. Low leverage and decent access to financing are also potential positives, since lending generally is likely to remain difficult and expensive," says the report.
China and Singapore meet these criteria, in their view. On the other hand, UBS continues to see risks in markets with elevated leverage ratios and an overreliance on external demand, such as Korea. All in all, it expects continued weakness in emerging market equities.
The bank suggests focus on strong valuation and resilient profits. "We expect corporate earnings to continue to decline in 2009. Therefore, we advise investors to remain defensive and focus on regions with credible valuations, such as Europe and Japan. Eurozone and UK large caps offer good long-term value under various conservative assumptions and that they already largely discount many of the difficulties that we forecast for the year ahead."
Coming to bonds, both corporate and government, in the emerging market, UBS believes the stiff winds that kicked up against this market in 2008 will carry over into 2009. It explains three main factors that sent asset prices tumbling in 2008, leaving emerging markets with a lower level of US dollar income.
The first blow to asset prices came from the slowing global economy. The second problem came from investors who moved their dollars from higher-risk assets – including emerging market equities, bonds and currencies – into more liquid markets. As long as global risk aversion remains elevated, emerging market asset prices are likely to suffer.
The third factor, constrained access to capital markets, arose with great speed. For emerging market companies, inaccessible international capital markets meant they could not easily raise new capital via initial public offerings, bond issuance, syndicated loans, overdrafts and letters of credit.
The lack of such funding puts even healthy businesses at risk of seeing a liquidity squeeze grow into a solvency crisis. In such an environment, the credit rating of sovereign governments themselves can come under pressure, it says.
"When the credit crisis hit emerging markets in 2008, the level of their external debt, as a percentage of the size of their economies, was at its lowest in a quarter-century. This reflects the extent to which the emerging markets had become net lenders to the rest of the world. It also suggests that many emerging market countries, especially in Asia, are in better shape to deal with the current financial market woes than they were in some previous crises."
The credit crisis impacts countries differently, depending on a range of factors, including who is, and is not, a net creditor, the extent to which a country's corporations are dependent on foreign borrowing, the share of foreign ownership of bonds and equities, the openness of capital accounts, and the currency regime in place, it adds.
In an environment where credit is scarce and expensive, cash is obviously king. Accordingly, countries with large current account surpluses such as China and some of the oil-exporting states are better able to deal with the crisis than countries with current account deficits, the report mentions.
Across the board, though, it is clear that the external financing situation for the emerging markets will be weaker in 2009 than it has been in recent years.
On balance, this speaks for weaker emerging market currencies and weaker credit metrics, it ends.
European equities better than emerging markets
A potentially deep and prolonged global recession, with corrosive effects on company earnings, means that investors face a difficult year in 2009, says UBS in a report on global outlook.
In this challenging environment, we prefer an approach that focuses on long-term valuation, as inexpensive markets and sectors tend to deliver above-average returns after the dust settles.At the moment, applying most standard earnings criteria yields a muddled valuation picture. Taking realised earnings into account, UK equities offer the lowest price-to-earnings (P/E) ratio since the early 1980s. Europe's P/E ratio of eight is 55 per cent below its average over the past decade. In the US, this discount has risen to 50 per cent. But focusing instead on more stable multiples, such as book value, suggests that conditions appear increasingly favourable in the Eurozone and the UK, the bank says.
To assess the reliability of traditional valuation signals in an environment of slowing global growth and high-risk aversion, we tested a number of scenarios using our dividend discount model. In our baseline scenario, which is based on earnings trends since the 1950s, equity markets offer considerable value.
Even if we assume a slower growth trend for profits and a higher-than-normal risk premium, Eurozone and UK equities still offer value, whereas the US equity market seems fairly valued. Swiss large-caps (that is, those stocks with the highest market capitalisation) appear mildly overvalued with this approach, it says in the report.
In sum, we conclude that Eurozone and UK large caps offer good long-term value under various conservative assumptions and that they already largely discount many of the difficulties that we forecast for the year ahead.
We believe the defensive sector composition of the Swiss equity market justifies selective investments despite its modest valuation disadvantage.
We note two additional factors that may benefit Eurozone and UK equities in 2009. The weakening of their respective currencies in 2008 improves the competitiveness of their companies, and both regions still enjoy some additional leeway for further interest rate cuts. These two factors take some of the edge off an economic slowdown for companies based in these regions.
In Japan's equity market, historical trends offer only limited guidance for assessing valuation after a lengthy period of deflation, economic stagnation and a sharp fall in equity prices. We think Japanese stocks have already factored in structural risk factors and no longer trade at a premium to global equities. At last October-end, the Nikkei 225 index briefly fell to its lowest level in more than 25 years. Despite the strong yen's drag on the export-dependent economy, we are optimistic about the outlook for Japanese equities given the strong valuation argument.
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