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Emerging markets: Basket case or buying opportunity?

08 March 2016

Ewan Thompson, manager of the Neptune Emerging Markets Fund, comments on why there are reasons for optimism in spite of a very difficult period for emerging markets in recent years.

By Ewan Thompson,

Fund Manager, Neptune Asset Management

Although emerging markets have been severely bruised in 2016 thus far, they have outperformed developed markets – highly unusual in a down market.

Global trade and commodity prices remain firmly under pressure, but more domestic investment propositions such as India and Indonesia continue to prosper economically. For investors with a medium to long-term time horizon, we believe there is a huge degree of upside from here.

 

Performance of indices in 2016

Source: FE Analytics

 

This year has clearly got off to a very difficult start, with markets generally recording one of the worsts starts to a year in memory. Although the price action has developed into a new, urgent phase, the underlying drivers are all very familiar, essentially boiling down to one core fact: global growth remains disappointing.

The volatility merely reflects a new phase of this macro economic backdrop that has blighted emerging markets since 2010. There is a new dimension now of course, and that is concern over the weakness of the Chinese renminbi.

Ongoing capital outflows from China are building pressure on the currency – previously pegged to the dollar, now to a wider basket of currencies – to depreciate. This is fairly reasonable considering the significant appreciation the currency has undergone since early 2014, during a period of widespread currency devaluations globally.


Although understandable, it does act to compound the problems already apparent in specific areas of emerging markets that compete directly with China, particularly commodity sectors for which Chinese buying power diminishes with a weaker currency.

Essentially, what emerging markets like is global growth, global trade, rising inflation expectations, stable or rising commodity prices and increasing global liquidity. Sadly all of these factors are conspicuous by their absence.

They are also all linked in one way or another to the fortunes of the US economy via Fed monetary policy and the trajectory of the US dollar. The trade-weighted dollar has been rising steadily since mid-2011, and more aggressively since mid-2014 – this sucks liquidity out of the global financial system, pressurises commodity prices, pushes down inflation expectations and weighs on global trade and by extension growth.

 

Relative performance of currencies over 1yr

 

 

Source: FE Analytics

 

What is encouraging, however, is the degree to which the factors above have been fully in play for five years now, and thus these are not new developments unknown to the market. Whilst emerging markets are relatively cheap, they are not at all-time low valuations due to the constant earnings downgrades. However, the valuation story begins to hold more water when compared with developed market valuations.

The relative valuation of emerging markets to developed markets is at global financial crisis lows, illustrating that the difficult operating environment is considerably more priced into emerging markets than developed. Although emerging markets have been severely bruised in 2016 thus far, it is interesting that they have outperformed developed markets (albeit marginally) - highly unusual in a down market.


 

Performance of indices in 2016

 

 

Source: FE Analytics

Moreover, we must be careful to disaggregate the basket of emerging markets. Those tied to global trade and commodity prices remain firmly under pressure, but more domestic investment propositions such as India and Indonesia continue to prosper economically. Also at the sector level, whist trade-sensitive sectors and commodity companies suffer, high quality domestic-focussed companies are holding up well.

It is difficult to know exactly when the macro-backdrop will finally turn the corner in emerging markets’ favour, but this is not the be all and end all.

There are plenty of opportunities out there, but also plenty of risks. We believe that an active approach that seeks to identify and avoid these risks whilst backing the rare opportunities will bear more fruit than simply sitting and waiting for the exact point to buy the entire asset class. For investors with a medium to long-term time horizon, we believe there is a huge degree of upside from here.

 

Ewan Thompson is manager of the Neptune Emerging Markets fund. All the views expressed above are his own and shouldn’t be taken as investment advice.

 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.