beyondbrics

It’s been a good year so far to be an emerging market equities investor, to say the least. The MSCI Emerging Markets Index surged 11 per cent last month – its strongest January in 11 years, rebounding from a 21 per cent tumble last year – and is currently at its highest level since August.

And it seems that fund managers are counting on more EM joy still. According to a monthly survey by Bank of America Merrill Lynch – considered a barometer of sentiment in financial markets – there has been a “stunning rise in asset allocation to EMs” in February. Even after last month’s stellar performance, the jump towards EMs is the second biggest in the past 12 years.

Why the bullishness? According to BofA:

Thanks to a stronger policy response in Europe and better-than-expected macro data around the world, asset allocators significantly increased their exposure to EM equities this month… Unsurprisingly, this surge in EM exposure coincided with an improvement in FMS risk measurements (lower cash levels, higher equity allocations) and stronger expectations for global growth.

The outlook for Chinese growth, which BofA says is “arguably the most important barometer of EM sentiment” was perceived as the strongest it’s been since November 2010. That’s thanks to an improvement in global growth expectations: after spending much of last year predicting a recession, a net 11 per cent of fund managers now reckon the global economy will improve over the next 12 months.

China regained its position as the most favoured EM in February, having been overtaken by Brazil last month. There were also big swings in favour of Turkey, now the third-most popular EM, and Mexico, which went from being more than 20 per cent “underweight” to around 5 per cent “overweight”. And Indian equities, though still lagging behind their peers, saw a “massive rally”, said BofA.

Across EMs as a whole the mood is most definitely risk-on, with cyclical industries in favour – particular the financial services industry, which suffered a torrent of negative sentiment toward the end of 2011.

The strong improvement in the macro outlook spurred a massive shift in EM sector allocations to Financials: the sector went from a huge underweight (-44%) to modest overweight (+7%) in February. And as fund managers became more constructive on global growth prospects, they reported increased holdings of Materials (+7%) to the highest level since April ‘11. Other cyclical sectors also attracted additional interest.

Are investors setting themselves up for a fall? Some analysts think so – and BofA says the bottom line is that exposure to EMs in now “dangerously high”. It notes that the most investors are overweight EMs since December 2010, at levels which, historically speaking, have coincided with short-term underperformance.

Then again, the MSCI Emerging Markets Index  is still around 13 per cent down from its 2011 peak, and investors worldwide are apparently hungry for risk. Given that a net 36 per cent of the global panel surveyed – with more than $600bn of assets under management – said they’d most like to “overweight” EM equities over all other regions, this rally might have a while to run still.

Jerome Booth, Head of Research at Ashmore Investment Management, questions the assumption that current investor bullishness about EMs is unsustainable. He told the FT: “To say that they [EMs] are overweight begs the question – overweight what?… One might well conclude that at least half the world’s future income is likely to come from the emerging world.  Traditional indices may be useful for benchmarking performance but not for asset allocation.  Arguably most investors in the developed world are still horrendously under-weight emerging markets.  As they realise this, in large part because they are making fundamental reassessments of risk in the developed world, they are catching up . A bit.”

His conclusion? “This is not reversible as it driven by people discarding prejudices.  And prejudices are asymmetric: unlike knowledge, once lost they are not reacquired.  So there is probably more so-called ‘over-weighting’ coming”.

Related reading:
Growth expectations highest since July, FT
EM Fund flows: hungry for risk, beyondbrics
Blindfold metrics: EMs v the world, beyondbrics
Egypt: equities soar on political hopes, beyondbrics
2012: the return of the Brics? beyondbrics