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El-Erian: Be Picky on Emerging Market Investing in 2014

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Three primary factors were behind the significant underperformance of emerging markets in 2013, says Mohamed El-Erian, and while those specific factors may not recur this year, that doesn’t mean investors should expect an EM recovery that is “broad in scope and large in scale.”

Writing in his Financial Times blog on Wednesday, PIMCO’s CEO and co-CIO said that in 2014, EM investors should rather “differentiate by favoring companies commanding premium profitability and benefiting from healthy long-run consumer growth dynamics.”

Emerging markets’ underperformance in 2013 affected “virtually every asset class,” he reports, including equities, sovereign bonds and the worst-performing asset class, local currency EM bonds, which returned a minus 9%.

El-Erian writes that were some “classic” factors at play in emerging markets last year — revenue that suffered due to “more muted growth and lower government stimulus, with related global demand uncertainties,” lower profit margins and concerns over corporate governance and political instability in certain EM countries. EM equities also weren’t able to take advantage of the “financial engineering” practiced by developed market corporate treasurers who took advantage of G3 central banks’ easy-money policies to buy back shares (he says U.S. companies were authorized to do so to the tune of $750 billion).

Three specific factors also weighed on EM performance in 2013, he says. First was the narrowing of the “EM dedicated investor base,” or as he writes, due to the Fed and other central banks’ actions, “’tourist dollars’ fleeing emerging markets could not be compensated for quickly enough by ‘locals.’”

Second was the failure of emerging-market corporate and political leaders who, he says, “underestimated exogenous technical shocks, overestimated their resilience, and under-delivered on the needed responses at both corporate and sovereign levels.”

Third, “internal policy incoherence” in emerging markets was “accentuated by the currency depreciations caused by the sudden midyear reversal in cross-border capital flows.” El-Erian says that “absent a major hiccup in the global economy,” those three factors’ influence will likely diminish this year, which will improve EM assets, whose “valuations have become more attractive on both a relative and absolute basis.”

However, El-Erian concludes that while EM investing’s 2013 performance was broad-based and despite those current attractive valuations, 2014′s EM outperformers will be individual companies that are most likely to be found in EM countries that have strong balance sheets, exhibit a “high degree of policy flexibility” and that will benefit from a “rising dedicated investor base.”

Check out Bob Doll: 10 Economic Predictions for 2014 on ThinkAdvisor.