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Why emerging markets might double your money over four years

03 June 2015

GAM’s Tim Love explains how a combination of earnings growth, healthy dividends and valuation re-rating could significantly boost the returns of emerging market equities.

By Lauren Mason,

Reporter, FE Trustnet

Emerging market equities are set to deliver returns of almost 100 per cent over the next four years, according to GAM’s Tim Love, despite a recent dip in investor sentiment towards the asset class.

The manager of the JB Emerging Equity fund has based his prediction on a price-earnings ratio increase in the sector from 12 to 14-15 times, dividends of around 3 per cent and earnings growth of approximately 15 per cent.

His bullishness towards emerging markets, however, comes at a time when many investors are considering selling down their exposure to the sector.

In an article published yesterday, FE Trustnet research showed that more than 85 per cent of emerging market and frontier funds have been unable to outperform cash in the two years following 2013’s ‘taper tantrum’, when it was first hinted that the US central bank would end its quantitative easing (QE) programme.

Since then Federal Reserve chairman Ben Bernanke made the announcement on 19 June 2013, the MSCI Emerging Markets index has failed to recover and is trailing behind the MSCI World index by more than six times.

Performance of indices since taper tantrum

 

Source: FE Analytics

What’s more, the Fed rate hike on the horizon is worrying many investors, prompting fears that the already-flat performance of emerging markets could plummet once more in a similar fashion.

Ann Stupnytska, economist at Fidelity Worldwide Investment, said: “The taper tantrum of 2013 and the bund rout of late have given us a flavour of the type of market reaction we can expect if US interest rate rises occur more quickly than expected. Given the size of positions and liquidity issues in certain markets, the potential for outsized market moves would pose serious risks to global growth.”

Despite the potential macroeconomic headwinds facing the out-of-favour market, Love believes that the concern over rate hikes impacting emerging markets is misguided.

“Emerging markets have historically done very well post a hike in US interest rates, typically delivering an uplift three times higher than the proceeding down phase,” he pointed out.

“A normalising of the US yield curve in the next three to six months will be a starting pistol to become more aggressive on deep cyclical stocks, for example shipping and rare commodity stocks. In order to make the most of the opportunity investors need to buy ahead, as soon as a bottoming out of lead indicators becomes visible. The key, as always, will be allocating capital at the right time rather than being paralysed by fear.”

Additionally, the fund manager believes that investors will move their money from fixed income into equities as their risk appetite recovers. Combined with inflows from captive pension funds, Love says that the growth of emerging markets will be adequately supported.

“The secular demographic growth drivers for the region also remain intact, particularly the growth in the young population and increased disposable income,” he added.


However, there is still a need to differentiate between the countries that fall under the broad ‘global emerging markets’ banner.

For instance, Love explains that, because the lower oil price has benefitted the importers such as India, China and South Korea, the fall can be played in these countries through consumer sectors like cheap airlines and electronics, which have outperformed state-owned enterprises through removing ‘intermediaries’ in the supply chain.

China in particular has sparked Love’s interest recently following a market rally which has boosted some of his fund’s A-share holdings by more than 40 per cent.

In fact, since the start of the year, the MSCI China A index has outperformed the MSCI World index 52.38 percentage points, delivering returns of 58.72 per cent.

Performance of indices in 2015

 

Source: FE Analytics

Despite having reduced their China overweight slightly, the manager and his team believe that the restructuring of China’s financial markets means that share prices still have further to run.

“The reforms will benefit state-owned enterprises and private companies alike. The healthcare, consumer, energy and banking sectors all offer opportunities, but it is the quality of earnings at a company level that really counts,” Love said.

In contrast, Miton multi-asset manager David Jane told FE Trustnet earlier this week that Chinese equities are likely to be the only ones in the asset class that are set for trouble in the near future.

He said: “The headwind of the rising dollar was the thought process behind not holding emerging markets – they are very dependent on commodities. I’m trying to avoid the aftermath of when China blows up, and I think the ripples that can roll through as a consequence of that might be quite uncomfortable.”

“China is certainly in a bubble. It has all the characteristics – mad retail investors borrowing money, as well as obvious opportunity to do ‘money laundering’ via Shanghai into Hong-Kong and absurd valuations and companies with no business whatsoever at comically high valuations.”

Another unloved country that Love is watching closely at the moment is Brazil, a market that has the ability to turn even the most bullish of investors pale.


Despite an unfortunate combination of headwinds including slowing growth, rising inflation, increasing debt and a huge corruption scandal surrounding Brazil’s national oil company Petrobras, the manager believes that the volatile market has provided the opportunity to snap up a bargain.

“Brazil has been a significant underweight in our portfolio, but is close to an interesting entry point as a deep value play. The country’s recent set-backs are now priced into share prices and there are opportunities in sectors including housing, retailers and oil,” he explained.

In terms of frontier markets, Love’s fund has a strong overweight to Saudi Arabia due to the opening up of the capital markets this month. He also thinks there will be a valuation uplift in Argentina, as he believes the election in September will bring a “modest bias” to pro-market reform.

However, he has reduced his exposure in India from 12 per cent to 9 per cent, following a poor earnings season. Despite this, his positioning remains overweight as he believes the market will pick up following impending political changes, which will prioritise infrastructure and tax incentive beneficiaries.

“To successfully capture [emerging markets’] growth potential investors need to focus on stocks with strong free cash flow, dividend coverage and robust balance sheets. Staying on the right side of global currency moves will also be key,” Love advised.

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