Sell emerging markets, Goldman and JPMorgan say

Wall Street's biggest banks say the slump in emerging-market assets that left equities trailing advanced-nation shares by the most since 1998 last year will prove more than a fleeting selloff. The Goldman Sachs Group Inc. recommends that investors cut allocations in developing nations by a third, forecasting “significant underperformance” for stocks, bonds and currencies over the next 10 years. JPMorgan Chase & Co. expects local-currency bonds to post 10% of their average returns since 2004 in the coming year, while Morgan Stanley projects the Brazilian real, Turkish lira and Russian ruble will extend declines after tumbling as much as 17% in 2013. While the economies of Brazil, Russia, India and China symbolized the increasing power of the developing world during the worst of the global financial crisis and delivered outsized returns, Morgan Stanley says some of the same nations may now prove to be laggards as the U.S. Federal Reserve scales back unprecedented stimulus and interest rates rise. The MSCI Emerging Markets Index is down 3% this year, compared with a 1.1% drop in the developed-market index, and hit a four-month low yesterday as data from China showed weakness in manufacturing and services. “The world not long ago was so mesmerized by the emerging markets without distinguishing the good from the bad,” Stephen Jen, a partner at SLJ Macro Partners who correctly predicted the selloff in developing nations last year, said Dec. 18. “The cost of capital will start to normalize and that's when we see the truth being revealed in these markets.” Emerging-markets local-currency bonds returned 205% in dollar terms in the decade through 2012, compared with a 58% gain for U.S. Treasuries, according to data compiled by JPMorgan and Bank of America Corp. The MSCI index of stocks advanced 261%, outpacing the 69% rally in the developed-market measure. Last year, domestic bonds in developing nations lost 6.3%, the most since 2002 when JPMorgan started compiling the data. The MSCI emerging-markets equity gauge declined 5%, compared with a 24% rally in MSCI's World Index, the biggest underperformance in 15 years, according to data compiled by Bloomberg. “It's a structural de-rating that's taking place” in emerging markets, John-Paul Smith, a Deutsche Bank AG strategist in London, said Dec. 18. Developing-nation stocks will trail their peers in advanced economies by a further 10% in 2014, he said. The recovery in developing economies, which contributed to 65 percent of the global expansion since 2010, is struggling to gather momentum as exports grow at the slowest pace in four years. China, which buys everything from Brazil's iron ore and Chile's copper, is facing the threat of bank failures as local government debt has increased 20% annually since 2010. While emerging markets still still expanding faster than developed countries, the margin will shrink this year to the smallest since 2002, according to Credit Suisse Group AG. The growth rate in advanced economies will almost double to 2.1% this year, while emerging markets are expected to expand 5.3%, compared with 4.7% in 2013. PESO, REAL Investors still can find value in developing nations as they differentiate economies based on growth momentum, inflation and balance of payments, according to Sara Zervos, who helps oversee $15 billion in assets at Oppenheimer Funds Inc. Mexico's peso appreciated 14% against the Brazilian real last year as President Enrique Pena Nieto opened the oil industry to private drilling for the first time in 75 years. South Korea's won-denominated bonds returned 2.6% as its current-account surplus reached a record high. “There will be a competition for marginal capital flows,” Ms. Zervos said Dec. 20. “There will be winners and losers.” Investors should favor the Mexican peso, South Korean won and Indian rupee, while avoiding the rand, real and rupiah, she said. Aberdeen Asset Management PLC and HSBC Asset Management said valuations in some developing nations are becoming attractive after the recent selloff. The MSCI Emerging Markets Index traded at a multiple of 10.3 times projected 12-month earnings, compared with 14.9 for developed markets, the biggest discount since 2006, according to data compiled by Bloomberg. Adithep Vanabriksha, the chief investment officer for Thailand at Aberdeen, says he is buying Thai stocks as valuations fell to the lowest levels in 18 months. Rakesh Arora, the head of research at Macquarie Group in Mumbai and India's most accurate equity forecaster, says the S&P BSE Sensex will advance 13% in 2014. “When people are running away, we are happy to get in,” Guillermo Osses, who oversees $14.5 billion as the head of emerging-markets debt at HSBC Asset Management, said Dec. 19. Osses said he's buying the currencies and short-term debt in Brazil and South Africa following their slumps. The Fed said Dec. 18 that it plans to take the first steps toward cutting the stimulus that helped fuel the credit boom across emerging markets over the past five years, by reducing its monthly bond purchases by $10 billion to $75 billion. Even a small capital outflow and increase in borrowing costs will have adverse impacts on governments and companies in developing countries as debt levels increased, according to Morgan Stanley. Net debt amounted to 1.25 times earnings before interest, taxes, depreciation and amortization for companies in the MSCI's emerging-markets gauge, up from 0.68 in June 2009, according to data compiled by Bloomberg. Average borrowing costs for developing-country governments jumped to 6.96% on Jan. 2, the highest since March 2010, according to JPMorgan's GBI-EM Diversified Index. “We're at the mature end of the credit cycle in emerging markets, which suggests we may see increased financial-sector and fiscal risks, which are not priced in by the markets,” Rashique Rahman, co-head of foreign-exchange and emerging-markets strategy at Morgan Stanley in New York, wrote in an e-mail Dec. 18. GOLDMAN'S CALL Morgan Stanley recommended investors reduce holdings of emerging-market currencies and bonds on Dec. 3, saying the developing world “faces the challenge of regaining a decade of lost competitiveness.” The bank labeled Brazil, India, Indonesia, South Africa and Turkey as the “fragile five” in August, because of their reliance on foreign capital. Goldman Sachs advised clients to cut their emerging-market allocation to 6% from 9%, citing the lack of economic reforms to improve growth, CNBC reported on Dec. 22. JPMorgan expects a return as low as 1 percent for local-currency bonds this year, compared with an average gain of 10% over the past decade, according to its 2014 outlook report. As economies in developing nations slow, political and social tensions are flaring. The Thai baht tumbled to a three-year low on Jan. 2 as anti-government protesters attempted to force Prime Minister Yingluck Shinawatra out of office. (Bloomberg News)