Over the year to date, the MSCI Emerging Markets index is up 6.83 per cent, just outperforming the 6.75 per cent rise in the developed market-focused MSCI World.
Emerging market stocks had climbed more than 14 per cent until concerns over the health of the Chinese economy and geo-political tensions sparked a strong sell-off in recent weeks.
The index has also outperformed the FTSE All Share, which is up just 1.82 per cent over 2014 so far but is well below the 10.68 per cent gain that has been seen in the S&P 500.
Performance of indices in 2014
Source: FE Analytics
However a note by Barclays analysts Ian Scott, Dennis Jose, Joao Toniato and Jason Hart argues that emerging market equities are no longer as attractive as they were at the start of the year and recommends they should be cut from an overweight to a neutral position.
The bank’s last recommendation was for a 19.5 per cent weighting to the asset class; this has now been reduced to 11.1 per cent.
Offering three reasons for the downgrade, the analysts said: “The risk premium embedded in emerging market equities is now in line with developed market equities having been well above the developed market premium at the end of 2013, funds flow has returned to emerging markets suggesting that previously depressed sentiment has lifted [and] earnings estimates are still being cut.”
They added: “Although the direction of US monetary policy has not been a dominant influence on emerging market equity performance in the past, the prospect of rising US bond yields ahead of Fed tightening in Q2 2015 could also provide a headwind for emerging market equities.”
FE Analytics shows Xavier Hovasse and David Young Park's €224m Carmignac Ptf Emerging Discovery fund has been the best performer from the IMA Global Emerging Markets sector over the year to date with a return of 15.51 per cent.
It’s followed by Dr Mark Mobius’ Templeton Emerging Markets Smaller Companies, Rob Marshall-Lee’s Newton Global Emerging Markets, Amit Mehta’s JPM Emerging Markets Small Cap and David Shaw Stewart, Francis Seymour and Guido Bicocchi's McInroy & Wood Emerging Markets funds, all of which have returned more than 10 per cent.
However, as the analysts cut their recommendation for emerging markets they also upgraded the outlook for Japanese equities.
Barclays previously suggested a neutral weighting of 7.3 per cent to the asset class but this has been boosted to an overweight 17.4 per cent in the latest research.
Japan’s Topix is currently trading around the 1,345 mark, having risen 30.14 per cent over the past two years.
Sentiment towards Japanese equities has been boosted by the policies brought by prime minister Shinzo Abe after the December 2012 general election, which revolve around "three arrows" of fiscal stimulus, monetary easing and structural reforms.
However, its performance over the year to date has been much more muted with a gain of just 0.85 per cent after investors became more cautious on how effective the ambitious ‘Abenomics’ programme will be in reality.
Performance of indices in 2014
Source: FE Analytics
Barclays points out that the Topix only recently broke through the 1,300 barrier, having failed on three previous occasions over the last 18 months.
It notes that this time things have been different because of an apparent lack of heavy buying from foreign investors, which it claims “makes it more likely that the market will continue its recent rise”.
In addition, the analysts point to other factors which support the case for more optimism in Japanese equities.
Companies have not reacted to periods of yen weakness by cutting prices in international markets which has allowed their profitability to rise, while this extra profit has been used to strengthen balance sheets rather than embark on capex.
FE Research team has two Japanese equity funds on its Select 100 list of recommended funds - Baillie Gifford Japanese and Neptune Japan Opportunities.
Performance of funds and index over 5yrs
Source: FE Analytics
Sarah Whitley and Matthew Brett's £577.8m Baillie Gifford Japanese fund is first quartile in the IMA Japan sector over one and three years and, according to FE Analytics, is one of the best funds in the peer group when it comes to alpha generation.
It is also less volatile than the Topix.
The FE Research team said: “The portfolio is well balanced and there is no particular bias, although the team tends to avoid the mega-sized market capitalisation companies. Hence we expect its returns to be highly consistent and less volatile than its peers’.”
Baillie Gifford Japanese has a clean ongoing charges figure (OCF) of 0.77 per cent.
Chris Taylor's £389.9m Neptune Japan Opportunities fund, on the other hand, is one of the most volatile offerings in the sector but has witnessed periods of explosive growth.
For example, it returned 84.26 per cent in 2008 against the Topix’s 1.32 per cent return thanks to the FE Alpha Manager’s decision to short the index.
Taylor recently told FE Trustnet that his fund could make triple the return of the market over the next five years if his decision to hedge the portfolio back into sterling proves right.
The FE Research team notes that the fund has a more aggressive profile than its peers, making it more sensitive to economic cycles, and says its active currency management can allow positive returns in difficult periods - although this can backfire if its forecasts are incorrect.
Neptune Japan Opportunities has a clean OCF of 0.77 per cent.
Barclays’ analysts concluded: “In summary, we think it makes sense to increase exposure to Japanese equities at the expense of emerging markets.”
“Whether one looks at the valuations, the near-term earnings prospects or the fund flow environment, Japanese stocks appear to us to be more cheaply priced with better earnings prospects and with few signs of bullish sentiment amongst international investors.”
