×

Investors take a second look at EM as China fears cool

Emerging markets (EM) have faced the brunt of this summer's selloff, topped by volatile swings in Chinese stocks this week, meaning for many investors the region as a whole is more or less off limits.

But a growing number are now arguing that the supposed weakness -- largely fueled by fears of slower Chinese growth -- is overblown and recent market declines are more of a buying opportunity than a reason to sell.

Read MoreGlobal equity funds witness biggest-ever exodus

Investors watch computer screens at a stock exchange hall on May 8, 2015, in Fuyang, China.
ChinaFotoPress | Getty Images
Investors watch computer screens at a stock exchange hall on May 8, 2015, in Fuyang, China.

Asset allocators have largely looked to the euro zone, Japan and the U.S. for returns this year, as loose monetary policy has helped boost sentiment. Goldman Sachs this week maintained their overweight view on developed markets versus emerging economies in equities.

"Many EMs with small open economies, and exporters selling commodities to China, are likely to remain under pressure. Several also have their own imbalances to address, and yuan devaluation," the Goldman analysts, led by Chief Global Equity Strategist Peter Oppenheimer, said in a note.

Outflow debate

Emerging markets have seen significant outflows, which have accelerated in recent weeks as a number of commodity-exporting countries, such as Malaysia and Colombia, saw their currencies crash to lows not seen in nearly two decades.

But EM investing house Ashmore, which has around $60 billion invested in the region, said the recent reports of capital outflows from EM topping $1 trillion are inaccurate and in reality, outflows of this size never took place.

"No wonder this story grabbed the headlines. After all, $1 trillion is a big number, equivalent roughly to 3 percent of the EM's equity and fixed income markets combined," Jan Dehn, Ashmore's head of research, said.

Read MoreShanghai Composite widens gains to 5% in final half-hour

"If that much money had left EM it would indeed have been newsworthy. The actual outflows were much, much less – somewhere between $183 billion and $295 billion."

Data compiled by Citi published on Friday estimated that around $4.9 billion was pulled from Asian equity funds in the week ending August 26.

"Ignorance and prejudice about EM are rife. When combined they can become dangerous," Dehn added.

'Overly focussed' on China

China's Shanghai Composite index spiked on Friday to close up 4.8 percent, tracking the upbeat sentiment across the region underpinned by Wall Street's biggest one-day gain since 2011 on Wednesday.

This bounce in China followed new stimulus measures from the country's central bank this week, including an interest rate cut.

"In general, we believe the market is overly focused on the perceived risks to China and EM in general. For evidence of this, one need only look at the very negative scenario that valuations are pricing in," Ross Teverson, head of EM strategy at Jupiter Asset Management, said.

Read MoreCan South Korean stocks sustain their gains?

The average price-to-book ratio for stocks on the MSCI EM index is now less than 1.3 times, a level not seen since early 2009, when emerging markets were still reeling from the impact of the financial crisis, according to Teverson. A price-to-book ratio is used to compare a stock's market value to its book value, and is a key metric used by traders to gauge the value of equities.

Teverson also stressed that investors should take note of the cash sitting on some company's balance sheets, which means firms are able to comfortably cover costs, invest for growth and offers can potentially be redistributed among shareholders.

"If we look at individual companies, many are trading at levels where declining valuations mean that cash sitting on their balance sheets has become a significant proportion of their overall value," he said.

Small cap China Distance Education for example, a U.S.-listed Chinese firm that provides online vocational training courses, has cash worth almost 30 percent of its market cap, according to Teverson. Among the large caps, Samsung Electronics and semiconductor supplier Mediatek are both sitting on hefty cash piles.

Sweet spots?

Looking at outflows from emerging markets throughout August, analysts at UBS said that although volatility and correlation between assets in the space had clearly risen, they did not see any "tell-tale signs of large scale portfolio withdrawal."

The bank did forecast some further weakness from here and advised investors that foreign exchange markets were the weak link amongst EM assets, but the analysts remained bullish on other areas of the region.

"We have never thought that the Fed was EM's biggest worry, and have remained focussed on EM's own growth problems as the root cause of its underperformance," strategist at UBS Bhanu Baweja said.

Read MoreRevealed: the world's cheapest emerging market

In rates, UBS was positive on shorter-term maturities in Mexico, and Hungary – which it described as "attractive" payers – and in equities, the bank likes Mexico and Taiwan versus South Africa and Indonesia, respectively.

"For emerging markets, many roads do lead to China… however, as stock pickers, we have to consider what is already priced into stocks," Jupiter Asset Management's Teverson added.

"We believe that in recent months and weeks, the market has become disproportionately focused on risk rather than opportunity and that, while China faces challenges, there are reasons to be optimistic."