Emerging markets back after lengthy spell on sidelines

Emerging markets at last appear to have turned a corner following a six-year slowdown characterised by fears of a Chinese economic slowdown, a slump in commodity prices and a host of political scandals, which saw international investors scaling back exposure to these regions. 

The one thing these markets have had in their favour is attractive valuations, which remains the case. So is now the time for investors to return to the asset class, while the recovery is still in its early phases, especially given the fears over the possibility of the US stockmarket entering bubble territory?

Emerging market equities have certainly performed strongly over the past 12 months, says Katrine Husvaeg, senior portfolio manager at Russell Investments, but it is important to consider this in the context of the prolonged period of relative underperformance they have endured since 2010. Developed markets outperformed emerging by 68 per cent through to the end of 2015, creating a significant valuation dispersion between the asset classes.  

“Emerging markets have bounced off a low valuation base and have made up only a small amount of ground on their developed counterparts. While not quite as attractive as a year ago, they still trade at a significant discount to developed markets – the US in particular – and are also exhibiting higher expected earnings growth. The valuation argument remains valid in our view and there is more to come.”

Given the emerging market rebound, investors are naturally revisiting their exposure, claims Ms Husvaeg. Many institutional investors, especially those in the US, are underexposed to the asset class relative to global indices and their European peers, she reports. 

“US equities may be in bubble territory and the lower valuations and improving fundamentals of emerging markets, combined with general underexposure, should lead more money to return to these markets. Volatility, a consistent feature of emerging market equities, will offer good opportunities for those who are underexposed to add on the dips and for skilled active investors to uncover and exploit great trade opportunities.”

The Russell fund has maintained its tilt towards cheaper valuations, reflected by an increased exposure to the value factor, alongside higher exposure to the momentum factor, and overweights in markets including Russia and Brazil.  

Value is a good way to think about investing in emerging markets, claims Andrew Cormie, global emerging markets portfolio manager at Eastspring Investments, as over time it outperforms quality and growth. “But for three or four of the last five years value has been a pretty tough place to be. But we think that is part of the opportunity. And value did reassert itself in 2016 but it has a long way to go, and in early 2017 there has been some value headwinds again.”

Eastspring is underweight India, believing that although  the country is on the right path, it looks expensive. “Modi is doing some great stuff, and there is a lot to like there, but it is a popular place to invest,” he says. 

“We like buying things that are out of favour. Korea is our biggest overweight. There are some outstanding companies there that are selling at a discount because people have concerns.”

China central

Any discussion of emerging markets soon comes around to China. The country’s economy is slowly rebalancing, and fears that this would lead to a hard landing have impacted the global economy, and emerging markets in particular. Worries remain, in particular over the high levels of leverage in the country, but the government reported a higher than expected growth of 6.9 per cent in Q1 2017, which has certainly helped the emerging market renaissance.

“I have never subscribed to the views of these alarmists who say China’s debt is getting too high, because they are looking at China through the lens of a Western analyst,” says Mark Mobius, executive chairman at Templeton Emerging Markets Group. 

People forget China is a planned economy, he explains, with the main levers of the economy in the hands of the Communist Party, be it the banks or the major companies. “They can do whatever they want with the economy. If they are in trouble financially, they can bail out these companies.”

The country is moving towards a market economy with Chinese characteristics, explains Mr Mobius. “They will allow private companies to go under, they will let guys get arrested for fraud, but at the end of the day they will make sure that the employment situation is stable and that wages are rising at a good pace, so that they don’t have any political upheavals.”

Terms such as ‘hard landing’ and ‘property bubble’ terms are much abused when it comes to China, believes Sabrina Ren, portfolio manager, at Hong Kong-based JK Capital Management, claiming it is very easy to get worried about China because it is so big and so different to Western economies. 

“The mortgage market in China is very healthy, household savings are very high; for example you need an average of a 30 per cent down payment to buy a first home,” she says. “Anyone worried about leverage in China, and the loan book, mortgages is the last place I would be worried about.”

A gradually slowing economy is exactly what the country needs, says her colleague Fabrice Jacob, JK’s CEO. “The government has taken drastic action to shut down overcapacity,” he explains, highlighting how coal production is to be concentrated in just four provinces, while ultra high voltage power lines will revolutionise the national grid. 

He also highlights the steps the country has taken to tackle its pollution problem, giving the example of Taiyuan in Shanxi Province, which was the first city in the world to have an entirely electric taxi fleet. All 10,000 were replaced over a period of just six months, testament to how when the government wants to get things done, it gets things done. 

Back to normal?

From the aftermath of the 1998 Asian financial crisis through to early 2013, emerging markets massively outperformed developed markets – by a factor of 216 per cent versus 9 per cent in dollar terms, says Delphyne Deturmeny, emerging markets portfolio manager at Indosuez Wealth Management, driven by improving fundamentals and a pure growth story. From the end of 2012 until November 2016, however, they significantly fell behind fell behind as cycles of earnings were downgraded as countries entered new phases of economic development.

“In addition, over the same period oil prices plummeted by around 40 per cent, affecting oil-producers,” she says. “Although cheaper oil is generally good for oil-importing countries, mainly Asia ex-Malaysia, foreign investors saw it as a sign of a global slowdown and sold risky assets across the board.”

Now however, emerging markets have resumed their outperformance, and Ms Deturmeny is confident this trend will continue. She points to improved earnings, improved currencies, a stabilising oil price and the fact emerging markets are trading at a discount to developed markets while exhibiting superior growth rates. 

“In the short term, however, following the strong rally, we expect  investors are likely to take some profits in the coming weeks. In our view, this would represent a good opportunity to buy more emerging market assets.”

Emerging markets tend to be very cyclical and investors need to be aware where we are in that cycle, believes Anthony Collard, head of investments UK at JP Morgan Private Bank, explaining how this one started around 15 months ago and should therefore last for a reasonable time. JP Morgan has been adding emerging market exposure to both its advisory and discretionary portfolios, mainly in Asia. 

“When you look at emerging markets, Asia makes up about 70 per cent, so you are taking a big view on countries like China, India, Taiwan and Korea,” he says. “There are some brilliant stories on the side of that, be it Thailand or the Philippines. and you are making those bets, but you have to be cognisant of the biggest country weights.”

There are tactical opportunities to be found elsewhere, reports Mr Collard, for example currency plays in Mexico following the election of Donald Trump, along with local bonds in Brazil, while parts of Eastern Europe, and Russia in particular, look interesting. “But these are much more tactical process on a three to six month view, we are not saying now is the time to buy Latin America or emerging Europe on a two to three year view. We are not there yet.”

Julius Baer is recommending emerging market equities on a selective basis, and mainly to its Asian clients, says Heinz Ruettimann, strategy research analyst at the Swiss private bank. Although these countries appear to have turned a corner, rather than being in a bull market, he believes the market is currently in an “investment window”, with headwinds such as a stronger dollar and high levels of leverage likely to take their toll.

The bank’s favourite region is Asia, as return on equity is superior, and also more sustainable, than Latin America or Emea. “Key to our emerging market strategy is to identify countries with sustainable sales and earnings growth,” he explains.  “Compared to the other two regions Asia is lagging in terms of performance and earnings/sales growth. It has catch-up potential.”

Latin America and Emea have seen a strong rebound thanks to the low base effect, economies coming out of a recession and the rebound in commodity prices, says Mr Ruettimann, but if commodity prices do not have another uplift it will be difficult for these two regions to continue to outperform. 

China, on the other hand, has an important political year ahead of it with the 19th National Congress due in the autumn, and the government will want to keep the economy ticking over nicely. This should in turn keep the wider Asian economy stable.

Valuations and equity risk premiums in Asia look more attractive, while the region is also more robust from a macroeconomic perspective, he says. 

“Last but not least, emerging Asia has a tilt towards the IT sector and not towards energy and materials such as the other two regions,” says Mr Ruettimann. “The IT sector is a high growth sector and we believe earnings growth is more sustainable here than in the energy/materials sector.” 

Emerging markets are certainly a good growth story, says Didier Duret, CIO at ABN Amro Private Banking, but this is nothing new. The deregulation that is happening there is new, he explains, with countries like Indonesia, India, China and even Russia all active in this area. 

“There is a big change coming up, much like we had in the mid-1980s in the developed world. There is almost competition to deregulate, which is increasingly perceived by policymakers to be a key element in domestic success. Globalisation is forcing governments to adjust.” This trend is most obvious in Asia, for example in countries such as India and Indonesia which are looking to scrap subsidies.

In terms of access, he believes that emerging markets make a ripe hunting ground for active managers. 

“Early in the rally, ETFs were probably the cheapest and easiest way to go, but now there are good opportunities for alpha generation,” says Mr Duret. “Lots of funds are beating the benchmark because the benchmarks are stupid. They are not representative of the underlying economies.”

This problem goes further than the indices, he explains, as so much capital in these economies is in private hands. The theory of private equity in emerging markets is great, he adds, though gaining access is very difficult. “The name ‘private’ equity says it all.”  

VIEW FROM MORNINGSTAR: India and consumer staples take managers’ fancy

A switch in leadership style in 2016 saw the value style come to the fore, but looking at 2017, Morningstar’s Global Emerging Markets peer group shows some clear biases relative to the MSCI EM Index. 

At the country level the least favoured area is China, where in addition to the concerns over the rate of the slowdown in economic growth, a number of managers also have concerns over corporate governance, especially within some of the state-owned enterprises (SOEs). South Korea, Taiwan and Malaysia are the other main underweights. 

The most positively viewed country is India, which remains favoured due to its growth outlook. Managers hold different parts of the market depending on their views on valuation, but India is widely regarded as offering the best medium-term economic growth prospects among emerging markets.

At the sector level, active managers prefer consumer sectors, particularly consumer staples, again reflecting a quality growth bias and the over-arching theme of emerging market investment – namely increasing domestic living standards and therefore consumption.  

Underweights are less pronounced, but include energy, materials and IT, the latter including some large index constituents that divide opinion.

The JP Morgan Emerging Markets Equity Fund holds a Morningstar Analyst Rating of Bronze and has been formally managed by Leon Eidelman since July 2016. 

Mr Eidelman takes a long-term approach and focuses on quality growth firms. The quality bias is reflected in the fund’s return on equity, which is higher than its Morningstar Category average and the MSCI EM Index. 

The fund also has had a pronounced bias towards sectors positively affected by domestic demand and consumption, rather than areas influenced by commodity prices and currency moves. The approach may result in the fund underperforming for short periods if markets are driven by commodities, lower-quality names, or macro and political issues, but it has generally not shown significant weakness versus the category over more meaningful periods. 

Fidelity Emerging Markets holds a Morningstar Analyst Rating of Bronze and remains a strong option for investors, despite the relative weakness seen in 2016. Manager Nick Price has been at the helm of this fund since 2009 with impressive resources at his disposal. 

The investment process is predominantly bottom-up, with the team focusing on quality growth companies that exhibit: superior and sustainable return on assets; strong, unleveraged balance sheets; shareholder-friendly management; and reasonable valuations over a full economic cycle. There is a long-standing overweighting in South Africa/sub-Saharan Africa, where Mr Price sees structural growth opportunities. 

The portfolio shows clear biases to growth factors, higher valuation, and a higher return on equity than both the MSCI Emerging Markets Index and the global emerging markets equity Morningstar category average. 

Simon Dorricott, Associate Director, Equity Strategies, Morningstar