A buying opportunity has finally opened up in emerging markets, according to Kames’ Stephen Jones, as the chief investment officer has – after a long period of being underweight the asset class – upped his exposure thanks to the compelling valuations on offer.
There has been a huge change in sentiment towards emerging markets equites as having previously been most investors’ favourite asset class five years ago, it is now one of the most out-of-favour areas of the market.
This sea change has arisen due to various macroeconomic factors which have all intensified over recent months – such as China’s growth slowdown, falling commodity prices, political woes and the prospect of tighter monetary policy in the US.
This increased negativity is all too clear when you look at the performance of the asset class, as FE Analytics shows the MSCI Emerging Markets index has lost 8.3 per cent over five years, compared to a 58.30 per cent gain from the MSCI Developed World index.
Performance of indices over 5yrs
Source: FE Analytics
Given that China has been the source of the recent rout in markets as its economy is slowing and is pumping out deflationary forces around the world, many warn that there is further pain to come in emerging markets.
Jones, however, is confident that they are nearer the bottom than many believe.
“In terms of our asset allocation, we remain overweight risk assets. We continue to like UK and European equities and have recently neutralised our emerging markets exposure, having been underweight for some time,” Jones said.
“That’s based on the fact that there continues to be positive developments in terms of earnings, while at the same time there are now some cheap and compelling valuations on offer in emerging markets.”
“In a world where we are starting to see divergence in growth trajectories, you need to be careful with your stock selection. However, while headwinds still face China and emerging Asia, on balance there is a better opportunity to buy than there has been in the past.”
The further falls in sentiment towards emerging markets haven’t just affected the equity market (which is down 19 per cent since April), though.
Emerging market debt has also suffered, with concerns about currencies and potentially higher interest rates in the US pushing bond yields higher and higher.
In fact, since May 2013 when the US Federal Reserve first hinted it would reduce its quantitative easing programme, the IA Global Emerging Market Bond sector is down a hefty 15.38 per cent.
Performance of sector versus indices since May 2013
Source: FE Analytics
Again though, given the low yields and interest rates on offer in the likes of Europe, the UK and the US and as Jones doesn’t think an emerging market crisis is on the cards, he has been buying emerging market debt.
“We have come from a position of being very sceptical on emerging markets full stop. Now, we think much of the bad news is clearly in the price. In the context of the Fed holding rates and with earnings maybe not as bad as people first feared, now looks an attractive entry point,” Jones said.
“It is a balanced approach. Our view is that emerging markets have clearly been under pressure, but that is reflected in the valuation. We are not taking a huge overweight position here, but we think the chances of emerging markets getting ever cheaper seem much less likely.”
Though there are certainly many market commentators who remain very cautious on emerging markets, given the severity of the recent falls (and as they have underperformed for a substantial amount of time relative to developed markets), more are upping their exposure.
One of whom is Ben Preston, director of Orbis Investment Advisory, who says the fact that investors continue to pile out of emerging markets and into the likes of the US, UK, Europe and Japan is a very telling trend.
“When investors herd in one direction, prices rise and there’s a risk of overpaying. It is often safer to go the other way. Our research concludes that emerging markets are currently providing fertile ground for long-term investors: not just ‘despite’ being deeply out of favour, but perhaps even ‘because’ of it,” Preston said.
“The risk that really matters to investors is not volatility but rather the possibility of permanent capital loss, which comes about when you pay more for an asset than it is worth.”
He added: “The market’s stampede out of developing markets and into developed ones has resulted in a relatively wide gap in price-to-revenue ratios. Investors may be paying a dangerously large price premium for the perceived safety of developed markets.”
The MSCI Emerging Markets index is currently trading on a P/E ratio of 11 times, which is far lower than the MSCI World index’s P/E ratio of 17.69 times.
Despite that Nigel Cumming, chief investment officer at Canaccord Genuity Wealth Management, says investors should take a very measured approach to emerging markets.
He, for instance, is considering upping his exposure to Chinese equities (which have been hit the most during the recent sell-off) given sentiment is so low and valuations are depressed.
“Europe is a possible area of investment as indeed is China after its recent setback which in all probability will prove to be a much needed period of consolidation in a long-term bull market,” Cumming said.
“The 35 per cent correction in the A Share Index should be seen in the context of its 154 per cent rise over the past 12 months and anyway there are good investment opportunities using funds that stay away from this volatile exchange.”
Performance of indices since January 2014
Source: FE Analytics
Certainly, emerging markets have witnessed some sort of a recovery. In fact, the index is up some 15 per cent since the market bottomed in late September. Funds such as NFU Mutual Global Emerging Markets, Marlborough Emerging Markets and Baillie Gifford Emerging Markets are also up more than 17 per cent over the last month and a half.
However, Cumming says investors shouldn’t be piling in at this point in time.
“Whilst our mindset therefore is to look for opportunities to move our equity weighting to at least neutral from our present underweight, we are not going to rush at it.”
“Following such a significant market reversal, the most usual occurrence is for a relief rally which recoups some or all of the losses. This attempt to rally usually fails and the previous low is then retested. After this a second rally occurs and this rally is usually of some duration and substance.”
He added: “This process which is happening now can take a month or two to occur and we are therefore looking very carefully at appropriate entry levels for an increase in equity exposure.”
