Due to various macro-economic headwinds, sentiment towards emerging market equities has become increasingly negative with many investors favouring developed economies, such as the US and the UK.
Performance of indices over 3yr
Source: FE Analytics
Becket – who is chief investment officer at Psigma – says that sort of performance is likely to continue, as there are still a number of hurdles the developing world needs to overcome before the outlook becomes more positive.
However, Beckets says it is only a matter of when, not if, that these countries recover, and investors will miss out on decent returns if they try and time the market. “History suggests that we are now at both relative and absolute valuation levels that should lead to improved performance from emerging market equities, which we expect,” Becket said.
“However, experience has taught us that things are likely to get worse before they get decisively better (we can’t rule out a short term bounce) and whilst there has been some marginal selling of emerging market assets, we are yet to see the cathartic capitulation to extreme oversold levels.”
“We stand poised ready to increase our allocations as and when we get more clarity on the common and individual issues. Hopefully that will be soon.”
“What we are certain about is that if there is a major economic and market crisis in some (or most) of the emerging market economies, this will be a major problem for developed world equities,” he added.
While some of the emerging market nations have been plagued by political frictions and social unrest, Becket says that the major headwind facing investors is the slowing growth within the Chinese economy.
He says this is natural given the fact that the authorities are trying to change their economic model from investment to consumption. Becket adds investors should realise that it is bound to take a long time, but it shouldn’t be viewed negatively.
“In the end, we expect the Chinese authorities to be successful in their pursuits and this should lead to good performance from Chinese assets from their current lowly valuation levels,” he said.
Chinese equities were some of the worst performers in the global market last year. According to FE Analytics, the MSCI China has lost 11 per cent over the past 12 months while the wider MSCI World is up more than 7 per cent.
Performance of indices over 1yr
Source: FE Analytics
The manager points out, however, that there is more to the poor sentiment towards China than just the slowing growth.
Many industry experts have voiced concerns about the state of China’s financial system due to the rise in off balance sheet lending from the highly unregulated shadow banking sector.
Becket agrees that while the authorities attempt to tackle this problem, it could well lead to volatility in the Chinese market.
“In the immediate future it is impossible to predict the direction of China’s equity markets, not least because there are clear excesses in their financial system, which the Chinese authorities are actively trying to purge,” he said.
“China splurged a huge amount of cash on boosting the economy during the Great Financial Crisis in 2008.”
“Some of this spending was inefficient and there will be losses on this debt. At the same time loose regulation in an immature financial system has allowed some poor lending practices, especially involving local governments, and shoddy product creation in the wealth management industry,” he added.
Becket says that, as a result, Chinese default rates are likely to increase. This doesn’t, however, concern him too much as he says it will be short term pain for a longer term gain.
“What we don’t know is how many defaults there will be and to what extent the Chinese authorities will move to soften the blow. There is a valid argument that suggests for long term stability the government should let a lot of the debt fail.”
“This will be a long term positive but an incalculable short term negative,” Becket commented.
Outside of China, Becket says the “tapering” of Fed’s asset purchasing programme is likely to be another significant headwind facing emerging market investors.
Even since Ben Bernanke announced to the market in May that QE tapering was on the cards, both emerging market equity and debt markets have sold off significantly.
Performance of sectors over 1yr
Source: FE Analytics
Becket says that the major reason why that has happened is because the injected liquidity forces income seeking investors into the emerging markets which in turn drove up currencies and forced bond yields lower.
“Investors have invested in the emerging markets to try and achieve a yield and emerging market debt has been a favoured source of “carry” (excess yield),” he said.
“The increase in US bond yields has led to money (not a huge amount in truth) coming out of emerging market debt and currencies and returning to the “safer” developed world.”
“This has been painful for those countries that spend more internally than they make externally, because they are reliant on international debt markets.”
“The expected issues in raising fresh debt at moderate prices could lead to major economic problems in countries like Turkey and Indonesia.”
“Currency losses on existing bonds (and the expectation of further falls) could create a reticence of investors to buy new bonds, thereby creating a negative feedback loop.”
“We have seen elements of this already over the last eight months, ever since Ben Bernanke raised the sceptre of QE reduction,” he added.
However, Becket views both the normalisation of the Fed’s monetary policy and the economic slowdown in China to be relatively short term headwinds and as a result urges investors not to give up on their emerging market exposure.
“So, to conclude. Should we keep some exposure to EM assets? Definitely? Are things going to get worse before they get better? Maybe.”