Why Merrill Lynch Is Now Raising Emerging Markets Over Developed Ones

The RIC has been underweight in emerging markets since last summer. The concerns had been about rising debt levels and debt costs, a strong dollar, lower commodity prices and a potential for further currency devaluations, all of which are bad for emerging markets. The team said:

Now that the dollar is showing signs of peaking, commodity prices are firming, and Chinese monetary policy seems to be gaining traction, we are reversing that view. We are upgrading emerging markets to a narrow overweight in our equity allocation. A risk to our call is that the dollar renews its gains against emerging market currencies, which is the current view of our foreign exchange strategists. That would reduce the potential gains for dollar based investors.

Merrill Lynch strategist Ajay Kapur noted a few more issues, as follows:

  • Valuations are low relative to historical averages, but admitting that they have been attractive for a while and on their own were not a reason enough to increase exposure.
  • Emerging market currencies have become highly competitive and are also at historically attractive levels, helping profit margins by making their exports more desirable.
  • Falling capital expenditures in Asia and Latin America also help equity markets, as operating profit margins in emerging markets should rise versus those in the United States and Japan, where capex is likely to rise.
    Higher margins should lead to improved valuations, and analysts of many emerging market stocks are likely to be positively surprised.
  • Margins could improve further from the lagged impact of commodity price weakness into better trade terms, which is a leading indicator of Asia’s operating margins.
  • Merrill Lynch’s fundamental analysts in emerging markets are now more bullish than consensus on earnings growth for the first time in five years. Investors should expect more upgrades to emerging market earnings estimates.

On China, lower Chinese rates create favorable monetary conditions and are correlated well with emerging market stock prices. The firm does acknowledge that China still faces challenges of bad debt, as well as excess capacity and a potential for capital flight. Still, China’s easy monetary policy can allow a transition to a slower economy that is services driven and one where stock prices will benefit.

Outside of China, Merrill Lynch also sees an opportunity SOEs are expected to implement reforms. These entities account for around 50% of emerging market capitalizations. Kapur said:

Against a backdrop of more expensive and less available capital from developed markets, deteriorating fiscal positions and public backlash against corruptive actions, SOEs are likely to implement reforms that boost efficiency and returns. In Brazil, SOEs account for about 20% of market cap but exert a strong influence on employment, lending and social policy …

Regarding Brazil, driving forces for SOEs should be considered a new regulatory framework approved by the Brazilian senate, a new political equilibrium and improved cash flow given the end of a capex cycle.

Brazilian stocks and funds were weak on Monday after news broke that Brazil’s lower house declared the impeachment vote of Dilma Rousseff to be revisited due to procedural error.