Emerging markets remain an attractive investment

To what extent are the problems in the so-called developed world going to affect the performance of emerging markets?

The fragile, jobless recovery in the US has led to QE2, which has given a big boost to emerging markets. Here we can say that developed world problems are actually positive for emerging markets investors. On the other hand, these policy reactions have also caused appreciation of emerging market currencies which has triggered comments of a “currency war” and various measures (tax, interventions) to slow down or even counter this trend towards appreciation.

The real issue is whether at one point we will face a situation where investors believe that all instruments have been used without lasting positive outcomes, ie doubts would arise about the lasting character of the US recovery and hence about the effectiveness of QE2. At that moment, risk aversion would rise significantly and emerging markets would suffer because of portfolio risk being scaled back globally.

Do emerging markets still offer opportunities in the short-medium term as a group, or perhaps investors should be more selective in allocating money to this region?

Although emerging markets have outperformed developed markets there is still, for the asset class as a whole, a slight discount on a prospective 12 month price earnings basis, though this discount has narrowed quite a bit. Based on their better structural growth outlook, a position in emerging markets as a group remains recommended. Shorter term, we would favour South Korea and Russia, both on valuation grounds.

What is the most appropriate and effective way to manage an investment portfolio, given the great uncertainty in the economic environment and in asset class performance?

2011 will be a year where market timing and tactical asset allocation will be particularly important because the dominant theme at the start of the year – increased optimism about growth momentum in the US – will be different from the main theme mid year. If the US does OK, we should see increased talk about the “exit strategy” by the Federal Reserve, meaning when will we see the first rate hike in 2010, and nervousness in the bond market. This is not a “buy and hold market” because what works now won’t necessarily continue to work later on this year. The big challenge faced by investors is that depending on the scenario, a given asset class can be very attractive or lousy.

Getting the scenario right will be key. Suppose that we have surprisingly strong growth in the US, at least for a number of months: in such an environment equities will do very well. There will be a prospect of strong earnings growth in combination with ample liquidity, whereas bonds will suffer because of rising yields. Now suppose we have disappointing growth, at least for a number of months: in such an environment equities will do very poorly due to the prospect of disappointing earnings growth despite ample liquidity. On the other hand, bonds will rally strongly as yields collapse. One can assume that the pendulum of market sentiment will swing between these two extremes. Apart from focusing on getting the market timing call right, investors should also invest in asymmetric strategies offering some downside protection (eg absolute return strategies, stop-loss strategies).

The concept of multi-asset absolute return portfolios is still a very attractive concept because with lingering risk aversion, investors foremost want positive total returns (benchmarks are less relevant). Implementation should be based on very broad diversification and dynamic management. Diversification, to exploit the imperfect correlation between asset classes, has been harder to achieve because markets are moving more in tandem than in the past, reflecting a “risk on” or “risk off” attitude of investors. This makes dynamic management playing on the relative behaviour of markets and market timing – being in and out of equity markets – even more important than before.