Continued currency stability and a recovery in growth earnings must happen if emerging markets are to continue their stellar run, according to JP Morgan’s Emily Whiting, who says the easy money in the asset class has already been made in 2015.
The sentiment towards the sector overall seems positive in light of a Capital Economics report released last week entitled ‘Sun to continue shining on EM equities’. The MSCI EM index is up 14.12 per cent year-to-date according to FE data, which compares to 8.47 per cent from the MSCI World index.
Performance of indices since 2015
Source: FE Analytics
However, Whiting (pictured) urges investors to adopt a more selective approach to investing in light of the bounce, even though she remains cautiously optimistic about emerging markets in the medium term. 
“What we are maybe starting to see is a pick-up in the prospects for emerging markets,” she said.
“Clearly, the question of whether it means we outperform developed markets depends on what developed markets do. From an emerging market perspective, I think you’ve see a lot of the headwinds that we’ve faced in recent years, and if you think about the asset class, it’s underperformed developed markets significantly in the last three and five years.”
“You’re starting to see that moderate and potentially move the other way.”
“I think it will be very dangerous to suggest they will continue to outperform. What we want to see is emerging markets performing based on their own fundamentals again – that is how I’d position it.”
Since the start of the year, investor flows have poured into some emerging market regions. India has been one of the biggest beneficiaries since the game changing election last year, and the gradual recovery in oil price has even benefited the Russian market.
The picture over the longer term is not as positive however, with the MSCI Emerging Markets index badly lagging its developed counterpart over three and five years.
Performance of indices over 3yrs
Source: FE Analytics
The Capital Economics report released last week predicted that the bounce back is set to continue, even though growth in many regions will remain subdued.
While the report says it expects the Philippines and Mexico to deliver even higher growth over the next year than what was seen in 2004 and 2007, it predicts that all other emerging markets will deliver slower growth compared to this time frame, with China and Russia slowing the most.
GDP Growth Forecast (2015-2016) Less Annual Average GDP Growth (2004-2007) (%-pts)
Source: Capital Economics
“I think it’s natural that growth slows down,” Whiting said.
“I think we would all be very naïve to imagine that the growth you’ve seen in emerging markets over the last couple of decades can be repeated at the same level – what you want to see is sustainable growth.”
“As we all see with economies globally, what you don’t want to be doing is taking two steps forwards and then two steps back. You want to move slowly but surely in the right direction.”
The portfolio manager referenced China as an example of the fact that the slowdown of growth is a more negative outcome.
She explained: “You had Chinese growth at plus 10 per cent at a time when the economy was much smaller than it is now. As we all know, to double and then double again requires more and more each time or it’s not possible.”
“What you want is a sustainability of growth, and I think EM, in aggregate, is still delivering superior growth to the developed markets, which clearly has always been a big part of the emerging market story.”
Whiting acknowledges that expectations in most sectors, with the exception of information technology, continue to be lowered in dollar terms. However, when currency and a pick-up in growth take hold, she expects earnings upgrades to follow.
“I guess the crystal ball question is “when?”. You’ve seen earnings really struggle and, in our minds, that’s the big catalyst that we believe will really kick-start things again,” Whiting said.
“We would like earnings to recover soon, but as to whether it happens this year, I don’t know – I remember having similar conversations more than 12 months ago when we thought this might happen in the next quarter.”
“So, I really wouldn’t want to go out on a limb and offer any form of forecast which will undoubtedly be wrong. But, what I would say, is we believe that the disappointment and the headwinds are hopefully slowing down.”
The Capital Economics analysts seem to agree and expect emerging market equities to continue their strong performance, even in the context of slower growth and rising US interest rates.
“Looking ahead, we think there are reasons to be relatively upbeat about the prospects for emerging market equities,” they said.
“Granted, emerging market growth is likely to remain stuck at multi-year lows. What’s more, concerns about US rate hikes could resurface.”
“Still, the big adjustment in economic growth in the major emerging market economies has probably already happened, and as most of these economies have reduced their current account deficits in the past couple of years, they should be able to weather the onset of tighter Fed policy.”
“Against this backdrop, and with their valuations still relatively low, we think the future for emerging market equities looks comparatively bright”
Emerging market performance has been boosted by Asia this year, overshadowing a slightly negative return in EMEA (Europe, Middle East and Africa).
Performance of EM regional local currency stock market indices
Source: Capital Economics
When referring to JP Morgan’s Emerging Market Income fund, Whiting believes that the IT sector is a good example of why investors shouldn’t rule out emerging markets.
“We don’t just like IT because earnings have shot up – that’s more just a function of the type of stocks we offer,” she said. “We like IT because, firstly, it is very tied in with global demand. IT by nature is going to be a beneficiary in a pick-up of global demands. Clearly we’ve seen a developed market-led economy for the past couple of years.”
“You also find in IT that, because companies run themselves mostly to western standards, they have very good dividend cultures and that they are very aligned with minority investors.”
“They’re very focused on generating cash and playing that cash back to shareholders. When you think about countries that you like and, again, if we’re thinking from an income fund perspective, you don’t just look for the big dividends.”
Whiting uses Tesco as an example of why investors shouldn’t look for stocks that simply pay a big dividend, as if the company isn’t fundamentally great, shareholders will get bitten.
She believes that a combination of growth and yield, as well as a range of different EM markets, should be important factors when building a portfolio.
“You need to be selective though because, if you think about the first three months of 2015, you saw huge diversions in emerging markets. You had Greece down nearly 30 per cent, while clearly Russia had a great bounce back up over 20 per cent.”
“On a sector basis, you had IT up 8 per cent whereas you had other sectors such as the commodity-orientated ones fall. What you’re seeing is that this EM blanket that historically everyone spoke about, is showing itself to actually be a whole set of markets which are very different.”
“There is a real need to understand what drives all of these markets and there are great opportunities for active investors as a result of that.”