Emerging market equities to play catch up through 2014

“This year should be a good year for equities,” believes Harald Espedal, CEO at Skagen, the investment management company based in Stavanger, Norway, running $21.1bn (€15.5bn), mainly in equities. Its flagship global emerging markets (GEM) equity fund, Kon-Tiki, has $8.25bn in total assets.

This positive outlook for equities is supported by expectations for the global economy to grow by 3 to 3.5 per cent, with a potential surprise on the upside, low interest rates and a continuation of the cost deflation environment, which should enable corporates to sustain solid earnings. These factors are combined with lower than historical average equity valuations.

In particular, GEM equities are fairly out of fashion, but investors should look at them “from a contrarian point of view”, says Mr Espedal.

“The attractive structural growth story in emerging markets has been in the back run of investors’ mind, concerned about the worsening cyclical outlook,” he explains. This was reflected in heavy outflows from emerging market funds, negative returns and a contraction of pricing in terms of price earnings multiples.

“There is a lot of potential for emerging market equities if the mood shifts, and I think that will be the case for 2014,” says Mr Espedal. Emerging markets will also benefit from an improvement of the global growth outlook.

Last year, there was a deep divergence in stockmarket performance, with US and Japanese equities returning 20 per cent over the past 12 months and EM equities falling by 4 per cent. This year, as in the 10 year period from 2002 to 2012, there will be more convergence on the pricing of equities, predicts Mr Espedal. This convergence will have its anchoring in companies’ fundamentals, although money flows do play a role in the short term.

Unlike developed market equities, which are trading closer to their historical average, EM equities are trading at significant discount  – with a P/E ratio of 11, against an average P/E of 15.5 for the last 20-30 years – and considering their 1.5x price to book ratio, they represent “a good deal”, he says.

A few wobbles

However, volatility, which has been very low since Mario Draghi’s “whatever it takes” speech in the summer of 2012, is likely to increase. Investors should expect a market correction this year, of around 15 per cent, although this would not be by any means the beginning of a bear market.

The correction may be due to a sell-off for profit taking, or because of fears, or any risks that have not been priced in. Even during the bull market of 2003 to 2007 there were two significant corrections and investors tend to forget about them, adds Mr Espedal.