Investors shouldn’t fall into the trap of buying into emerging markets on the back of ‘attractive’ valuations, according to Hawksmoor’s Ben Conway and Rathbones’ Edward Smith, who say a large proportion of developing world markets are very cheap for very good reasons.
It won’t have escaped investors that emerging markets have endured a torrid time this year, following a series of headwinds including the Chinese growth slowdown and subsequent market sell-off, the plummet in commodity prices and impending US interest rate hikes, which threaten to push the US dollar up in value and increase dollar-denominated debt.
Performance of indices in 2015
Source: FE Analytics
As the market remains well below the likes of the FTSE 100 and MSCI Europe ex UK indices, however, the more contrarian investors could be looking to buy into the struggling market while valuations are cheap.
Trusts look particularly low-cost at the moment, with the likes of VinaCapital Vietnam Opportunity trading on a discount of 24. 2 per cent and Ashmore Global Opportunities trading on a discount of 24.2 per cent.
While these valuations may look attractive on the surface, Hawksmoor’s Ben Conway warns that emerging markets, and particularly Latin America which is dominated by the hugely out of favour Brazilian market, are setting investors up for a series of nasty value traps.
“There’s no value for us in LatAm trusts which is disappointing, and there would have to be an awful lot of value for us and big, big discounts to become interested,” Conway said.
“This is because the underlying stocks in emerging markets aren’t that cheap and this relates to a phenomenon we’re seeing across the globe in equity markets – there’s a huge amount of valuation dispersion in emerging markets.”
“Plain and simple, the reason why emerging markets might look optically cheap is because they’ve got a very high weighting in heavily cyclical companies or, in other words, commodity-based companies, and they drag down the aggregate. If you look at a consumer stock in Latin America or any emerging market and compare it to a consumer stock in the developed world, they’re not that much cheaper. That’s what it comes down to.”
“We don’t think there is an amazing valuation opportunity in emerging market equities and the reason they look cheap is simply because they’ve got a greater weighting in sectors that have done really badly, and there’s probably quite good reasons for those sectors to have done badly.”
During times of turmoil, it is commonplace for investment trusts that are worse hit to see their discounts widen. Conway says that, bizarrely, discounts have started coming in recently, which is a further reason that investors should hold off buying into emerging markets and Latin America particularly.
“If you look at BlackRock Latin America, for example, the current discount is about 10 per cent but that discount has been as high as about 15 and it averages 10 over the longer term,” he continued.
“Aberdeen LatAm is at a 5.5 discount and the average is actually 8 per cent so that’s expensive – it has been as wide as 12 per cent JPMorgan Brazil’s current discount is 3.3 per cent, while the average over the longer term is 6.6 per cent so again it’s expensive.”
“What you would usually expect after such a horrific performance is to see the NAVs of investment trusts falling obviously, but you should normally see a bit of capitulation from investment trusts as well, which forces the discounts wider and that’s when our contrarian noses start to twitch, but it hasn’t happened, which is weird.”
While the manager is unsure why discounts haven’t widened, he says that contributing factors could be RDR encouraging greater interest in investment trusts and boosting structural demand for retail, although he says this is simply a hypothesis.
Edward Smith, asset allocation strategist at Rathbones, believes that a “toxic” combination of shaky macroeconomic fundamentals, a dependence on credit and a slow growth rate has made him bearish on emerging markets.
“While some Asian and Eastern European economies have improved their current account balance since the 2013 Taper Tantrum hit emerging market currencies and equity markets, many Latin American countries are looking even more vulnerable today,” he said.
Performance of indices since the ‘taper tantrum’
Source: FE Analytics
“Second quarter GDP prints have been universally poor in Latin America, with many reports citing tumbling export demand from China as a key culprit. In terms of commodity-exporting economies geared into China, the likes of Venezuela, Chile, Brazil, Peru and Columbia are the most vulnerable, according to our research. Brazil looks especially fragile.”
As a result of dwindling consumption and weak investment expenditure, Smith believes that Brazil are almost guaranteed to face the worst recession since 1990, due to its government artificially supporting the economy – state pension payments currently equate to 3.5 per cent of the country’s GDP, which the asset allocation strategist describes as “alarmingly high”.
“Meanwhile, state-owned banks have propped up lending as private bank credit origination contracted. The new Rousseff government has realised its own mistakes and the fiscal crutch has been kicked away,” he added.
While some contrarian investors argue that the region has favourable demographics and a fairly large domestic market which offers protection against some macroeconomic headwinds, structural issues and a large deficit are turning a majority of investors pale on the region.
Neil Jones, investment manager at Hargreave Hale, hasn’t reduced his clients’ exposures to emerging markets as he believes they still offer some investment opportunities, but he would be deterred by funds with any significant weightings in Latin America or China.
“There are some decent funds out there and there are some good opportunities, but you’ve got to be careful of where they are allocated,” he said.
“An overweight in Latin America would deter me, and I am also mindful of having too much in China, which has obviously been a bumpy market recently.”
Performance of BRIC indices in 2015
Source: FE Analytics
“Somewhere like Russia, for example, has actually performed quite strongly this year, because it’s been such a bad market and got to a point where valuations were looking quite attractive. I think the fact that valuation looks cheap can be a good opportunity to buy things, but LatAm is particularly exposed to the resources side of things.
“Brazil has got a large oil resource base and that’s where valuation traps could exist, but I think generally there are some good developing markets out there.”
