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The catalysts emerging markets need to keep on rallying

24 August 2016

Neptune’s Ewan Thomson, Thomas Smith and Kunal Desai explain why various areas of the emerging market space have done so well this year and explain the backdrops they will need to continue to prosper.

By Lauren Mason,

Reporter, FE Trustnet

Low interest rates, further improvements to corporate governance and stable political backdrops are likely to be the main catalysts that will continue to boost emerging markets this year, according to a handful of Neptune’s emerging market managers.

Ewan Thompson, Thomas Smith and Kunal Desai – all of which run four and five crown-rated funds for the firm – say that now is the first time in more than five years that investors aren’t being rewarded for avoiding the market area altogether.

Over five years to the end of 2015, the MSCI Emerging Markets index lost 16.96 per cent while the MSCI World index was up 53.15 per cent. This significant underperformance was caused by a combination of the stronger dollar, general investor nervousness, the decline in commodity prices and fears surrounding China’s growth slowdown.

Performance of indices over 5yrs to 2016

 

Source: FE Analytics

Year-to-date though it is a very different story, as dovish statements from the Fed, a recovery in commodity and oil prices and concerns surrounding a number of developed markets have encouraged investors to buy back into the space.

Over the course of 2016 so far, in fact, the MSCI Emerging Markets index has outperformed the MSCI World by more than a third with a return of 29.84 per cent – this is also almost double the return of the rallying FTSE 100.

Thompson, who runs the five crown-rated Neptune Emerging Markets fund, said: “The key point to note is that the headwinds that have upset emerging markets in 2015 have, in 2016, turned into tailwinds.”

“Last year investors fretted about the Chinese economy possibly suffering a hard landing, this year its government has reacted quickly and in a concerted fashion to stabilise both the economy and the currency.”

“Perhaps more importantly than that, last year investors were worried that the US Federal Reserve was going to hike interest rates at exactly the time when global economies were still slowing. This year, however, the Fed has been much more holistic in terms of its approach, acknowledging global financial and monetary pressures in its decision making process and not just the domestic labour market.”

“This increased global coordination of monetary policy is incredibly powerful for emerging markets. We witnessed this in the way the emerging market’s outperformance completely shrugged off the much-feared Brexit decision in June.”

 However, while the manager says the macroeconomic backdrop for emerging markets has improved, he warns that there are still hurdles for the developing world.

“Emerging markets spent five years in the wilderness,” he pointed out.  “We believe the best long-term opportunities are among those economies that have used this time productively to address structural imbalances and introduce structural reforms or are undergoing major political reform such as we are currently seeing in Brazil.”

As is often mentioned with emerging markets, it is challenging to treat the market area as one broad umbrella category given the economic and market behavioural differences across various regions.


Brazil, for instance, has been the focus of significantly negative press over recent years due to corruption on both a both political and individual corporate level. In fact, the MSCI Brazil index is down an eye-watering 64.84 per cent over the last five years to the end of 2015, which is triple the loss that the struggling MSCI Emerging Markets index suffered over the same timeframe.

Performance of indices over 5yrs to 2016

 

Source: FE Analytics

In a complete reversal in fortune though, the Brazilian market is now rallying, having returned 82.66 per cent this year already compared to the MSCI Emerging Market’s return of 29.84 per cent.

Should the region’s sudden soaring performance be a sign to leave it well alone, or is there more room for growth?

Thomas Smith, who manages the four crown-rated Neptune Latin America fund, said: “Brazil has been in the spotlight in recent years but for all of the wrong reasons – the falling commodity prices, the vulnerability to the Fed hiking interest rates and the political crisis that’s unfolded has plunged the economy into the deepest recession we’ve seen in decades.”

“All of this has led the Brazilian market to fall 75 per cent in sterling terms from the 2011 high, significantly underperforming global and emerging markets.”

“These factors are now actually supporting Brazilian asset prices. The global tailwinds and the pending impeachment of Dilma Rousseff has improved the business climate. Brazil is making the necessary adjustments to reduce its vulnerability to global capital flows and the economy is bottoming.”

“With inflation falling, the central bank will now be able to lower interest rates which will stimulate economic growth and support market valuations. “

The manager says that, over the medium-to-long term, Brazil needs to see a more benign economic and political backdrop in order to take itself out of recession and points out that valuations are only just beginning to recover from stressed levels.

“Earnings will be supported by both domestic and global factors,” he added.

In contrast, the Indian market has been the darling of the emerging markets sector following the election of Modi in 2014, who achieved a landslide victory based on his push for pro-business reforms.


Over three years to the end of 2015, the MSCI India index returned 23.33 per cent while the MSCI Emerging Markets index lost 10.61 per cent.

Performance of indices over 3yrs to 2016

 

Source: FE Analytics

However, given the recent rally of the asset class, India is now lagging behind its peers year-to-date by 10 percentage points with a total return of 19.21 per cent. This could also be a result of some investors losing faith in Modi’s promise to reform the economy, with some arguing that two years later, many of his commitments have failed to materialise.

“It’s the turnaround in the economy since 2012 that has captured the world’s attention. India has enjoyed strong relative performance, outperforming both world and emerging markets by 15 and 30 per cent,” Kunal Desai, who runs the five crown-rated Neptune India fund, said.

“This strong outperformance has been driven by two things – firstly the sharp turnaround in the macro economy and secondly this very aggressive and pro-reform policy agenda set out by the government, most recently seen by the passing of the goods and services bill which has been in the offing for the past 16 years.”

“But looking ahead for absolute returns to come back in India, something more is required and that comes down to the corporates.”

The manager believes that investors will be positively surprised by another sharp turnaround in the region’s performance, which he says is likely to be caused by improved corporate profitability across individual companies. Given India’s economic backdrop, he believes that companies will soon hit their return on invested capital “sweet spot”.

“This has arisen because three factors have come together which very rarely happen in an emerging market capital cycle,” he explained.

“Excess capacity, rising demand and utilisation and continued balance sheet restraint by the individual companies. For us, over the next 18 months, this is the catalyst to watch as India looks to progress.”

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