Euro markets gain allure as east loses

LONDON - Reuters

Money has begun to shift from emerging markets to European and U.S. funds over the past couple of months. AFP photo

Western European economies are spluttering to life again at last just as emerging markets cool down - confirming one of the investment themes of 2013 and questioning how much financial markets have already discounted these inflection points.

While “sell high and buy low” may be an investment truism subject to myriad valuation and policy caveats, selling equity in cresting economies while buying it in troughing ones is a pretty well-worn global strategy.

And rarely has a contrast in economic momentum been as obvious as in this week’s global business surveys, which painted a stark picture of diverging trends between the developed world and emerging markets.

Private sector businesses in the long-dormant euro zone, for example, grew in July for the first time in 18 months while firms across the emerging world indicated a contraction for the first time in four years.

Yet even though that growth baton only passed last month, markets have been front-loading the likely switch all year.

So much so, that the blue-chip Euro STOXX index is up 9 percent so far this year while a dollar-based MSCI index of equities from leading emerging giants of Brazil, Russia, India and China have lost almost 13 percent.

The big questions on many investors’ minds is whether this week’s economic crossover is already long in the price and if there’s any more mileage in the switch.

For three main reasons - likely persistence of the relative economic trends and local monetary policies, relative equity valuations and cumulative fund flows - strategists reckon it’s too early to go into reverse.

“We continue to recommend an underweight on the emerging market universe,” said HSBC global strategist Garry Evans.Mutual fund investment tracked by Thomson Reuters’ Lipper show that money has shifted from emerging markets to European and U.S. funds over the past couple of months.

Fed reversal

However, cumulative one-year flows to euro-wide equity funds were still in negative territory to the end of the second quarter while equivalent flows to global emerging market funds were in excess of $120 billion.

“A lot of stale bulls remain in emerging markets,” said HSBC’s Evans, adding they may now be forced to sell if underlying fundamentals stay so poor.

And there’s little solace for developing markets on that horizon if U.S. monetary policy keeps playing a central role.

A likely U.S. Federal Reserve reduction in its bond buying stimulus by the end of the year looms large over all economies, but it has clearly hit emerging markets hardest in recent months given they had benefitted most from the Fed’s dollar-printing programmes of the past five years.

Not only has the prospect of a Fed reversal hit the currencies of Brazil, Russia, India, South Africa and Turkey this year by between 7 and 14 percent, it has forced many of their central banks to raise interest rates into mounting economic slowdowns just to stabilise exchange rates.

Stabilisation of the hobbled euro economies, meantime, has happened in parallel in part due to calmer regional debt markets but also as the drag from front-loaded austerity policies eases.

Yet still-high unemployment and weak credit growth mean the European Central Bank is widely expected to ease monetary policy yet again - as indicated by ECB policymaker Peter Praet - and this can help offset any Fed move.What’s more, there’s little sign that valuations show emerging markets are particularly cheap - especially when skews toward certain sectors such as energy and financial stocks in emerging markets are adjusted by assigning each country the same weighting as the global MSCI index.