Emerging Markets Look to China Reforms to Spark Rebound

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NEW YORK (TheStreet) -- Emerging market stocks are cheap but against a backdrop of sluggish global growth, investors have been reluctant to jump in.

That scenario may be beginning to change.

China, the world's second-largest economy and the undisputed heavyweight among emerging markets, plans to allow for changes in its financial sector that could help to reshape the economy. Over the weekend, Chinese policymakers said qualified private investors would be able to establish small-to-medium-sized banks that would compete with state-owned financial institutions.

News of the plan, among other proposed reforms, lifted the MSCI Emerging Markets Index for a second day, it's largest two-day advance since Sept. 10. Nonetheless,  the MSCI EM Index has lost 4.7% this year against a 27% gain for the MSCI World Index and a 26% increase for the S&P 500 Index. In defense of emerging markets, the MSCI EM Index has gained 6.9% since June 30.

The relative poor performance of emerging market stocks to developed markets has forced fund managers to more carefully chose their investments. Rather than picking a basket of stocks within a particular country, fund managers are having to select individual names.

"I no longer look at emerging markets as an asset class, the countries and their components are so different," Colin Bell, Auerbach Grayson vice-president of global emerging markets said in a phone interview. "We're undergoing a shift now, where countries that can fund themselves [their own current accounts] will perform relatively better [that those with large current account deficits]."

On a valuation basis, emerging markets certainly look attractive. Emerging market stocks trade at around 1.6 times book value - the value above their assets - against 2.5 times for U.S. stocks. Countries such as Russia and Hungary trade around 0.8 times book value. But many seemingly cheap countries are described as "value traps" by fund managers -investments appearing to present value that is unlikely to eventuate. 

There are two key reasons for this. The economic slowdown in many emerging markets is structural rather than cyclical, requiring a combination of government and monetary reforms to kick-start growth. For example, India has slowing growth, a widening account deficit and high inflation. The country's central bank has raised rates to fight inflation but this has crimped growth - with similar scenarios faced in Brazil and Indonesia.

Secondly, economies with large current account deficits such as Indonesia, South Africa, Turkey, Brazil and India have been fueled by cheap capital inflows from developed nations like the U.S. That scenario is likely to end with the anticipated wind-down of Federal Reserve stimulus, which is seen as potentially triggering capital outflows from speculative investment in emerging markets.

Fund managers say a key theme for much of the year has been to avoid emerging economies with deteriorating current account and fiscal deficits - a trend they expect to continue.