| NEW YORK
NEW YORK Emerging markets were facing headwinds going into 2014, but January's rout surprised even the gloomiest of investors, with big declines in stocks, bonds, and currencies.
Political turmoil and terrorism threats across market capitals from Ankara to Kiev, along with growing concern about bad debt in China's shadow banking system, caused a full-scale pullback across all risk assets.
As a result, some investors are starting to see attractive values in these markets. Sentiment remains weak, however, so the actions of emerging market policymakers will determine whether investors take advantage of low valuations or opt to preserve capital, strategists say.
"From our view, the valuations in this sector, be it hard currency (debt), local currency (debt), EM FX, corporates, are becoming compelling. Look, that is the first time I have been even close to bullish on emerging markets for a while. But it is on a relative risk/return basis," said Paul DeNoon, senior debt portfolio manager at AllianceBernstein in New York.
"The market has discounted a lot of bad news. I think with a lot of policy responses in the better countries, some opportunities have developed," he said, pointing to relative value in Indonesian, Brazilian and Turkish credits which have fallen far and fast.
In just a month, the broad MSCI Emerging Markets stock index is down 7.5 percent versus a decline of 5 percent for all of 2013, a year when developed markets surged by 30 percent. The benchmark U.S. S&P 500 stock index is down 3.6 percent year-to-date.
Yield spreads between emerging market sovereign debt and comparable U.S. Treasuries widened by nearly 50 basis points, according to JPMorgan's benchmark indices, the largest one month increase since June of last year when the Fed's first hint at reducing its monetary stimulus rattled global markets.
Turkey, India and South Africa have recently surprised markets with aggressive defenses of their currencies. Their actions come as the Fed moves toward more normal monetary policy that will cause less money to move abroad in search of higher returns.
Emerging market currencies have lost ground against the U.S. dollar and the euro. Bank of America Merrill Lynch (BAML) research said that in aggregate, emerging market currencies are now undervalued by about 2 percent, a sharp swing from 2010-2013 period when they were considered overvalued.
The bank sees cheap medium-term bonds in South Africa and Brazil. Mexico, Poland, Hungary and Malaysia look to be fairly priced, they said.
The aggressive rate hikes from central banks in troubled countries could stabilize those currencies, but it comes at a cost. Higher rates could slow growth in certain countries that are already struggling, and the weak demand from China means it will be more difficult for countries to export their way out of trade imbalances.
As fundamentals have not improved, emerging market countries with negative balance of payments metrics are in danger of more underperformance in their currencies.
"Our EM strategists believe some EM equity markets have further to fall, and that they require significant current account rebalancing before bottoming," wrote Goldman Sachs.
The Institute of International Finance wrote in its latest capital flows report on emerging markets that the asset class now has a price-to-earnings ratio for the coming 12 months, which gives a clue as to future corporate earnings, at about 9 times, below the decade average of 11 times. By comparison, developed markets are trading at a forward P/E of 15, above the long-run average of about 13 times earnings.
"Overall emerging market valuation has now fallen to very low levels," the IIF wrote on Jan 30.
To be sure, the IIF cautions that not every market is going to rebound. Many emerging markets - such as the now-famous 'fragile five' - face challenges in implementing structural reforms. These five - Brazil, India, Indonesia, South Africa and Turkey - are considered the emerging nations with the weakest balance of payment positions and most monetary policy uncertainty.
"The broad weakness in expected earnings over the next 12 months (with only China expected to see much pickup) is another warning that 'cheap' may not translate to 'rally' any time soon," the IIF, an association representing big banks, wrote.
Those countries have responded, to a point. After Turkey's central bank hiked its benchmark interest rate by 425 basis points, BAML said it is time do some "serious bottom fishing in Turkey."
"We think it's now right to be overweight on a full 2014 view," BAML said.
In addition to Turkey, central bankers in India and South Africa have taken aggressive action, which one veteran EM analyst said will be the deciding factor going forward.
"Policymakers could change valuation perceptions," said Daniel Tenengauzer, head of Americas research at Standard Chartered in New York.
He points to India's aggressive tightening, which stemmed the rout that country's markets experienced in the last six months. In that time India's benchmark BSE index has surged nearly 18 percent from a spike lower in August 2013.
In Latin America, he sees the acute selling of stocks such as Mexican telecoms giant American Movil (AMXL.MX)(AMX.N), down 6.2 percent year-to-date, as the result of Mexico's reforms, not just global factors.
Mexico has undertaken major reforms across multiple sectors. In the long-run reforms are positive but for companies like American Movil the near-term challenge will be a negative for its bottom line. Currently, the telecom company's P/E ratio is 11.3 on a forward 12-month basis versus its peers who are trading at 13.6 times earnings. The stock is down 6 percent in 2014, putting it at a 17 percent discount to its peers, according to Thomson Reuters data.
Strategas Research Partners believes Mexico is primed for more gains given reforms and its proximity to a strengthening U.S. economy.
The firm also believes Emerging Europe is poised for growth, citing in particular, Poland's promising prospects of a so-far resilient currency, low inflation, easy credit, and lower risk of capital flight. MSCI's Eastern Europe stock index trading against the MSCI Europe index, on a relative 12-month forward P/E basis, is below its long-term average, they said.
(Additional reporting By David Gaffen; editing by Andrew Hay)