Emerging markets have been the best performing region this year and a shift in fundamentals means they look severely undervalued compared to their developed market counterparts, according to Jan Dehn, head of research at Ashmore. 
Traditionally, emerging market equities have performed well during periods when sentiment among investors has been positive – such as during the build up to the global financial crisis and its immediate aftermath.
As such, many view emerging markets as a more cyclical play that are dependent on flows into the various markets and economies.
However, with a number of events impacting the developed world this year, including the EU referendum in Europe and the Federal Reserve’s unwillingness to raise interest rates in the US, emerging markets have outperformed
As the below graph shows, emerging markets have beaten the next best region (the US) by eight percentage points, and significantly outperformed major markets in Japan, the UK and Europe.
Performance of indices in 2016
Source: FE Analytics
Dehn (pictured) says this should be expected for some time and that perceptions the region is still a cyclical play are “wrong”.
“Perceptions about emerging markets (EM) usually lag behind reality, sometimes by decades. Nowhere is this more evident than in the perception about EM equities, where the consensus opinion remains that EM equities – and the MSCI EM index in particular – is primarily a commodities and cyclical play,” he said.
“This view is outdated and wrong. Today, the structural growth drivers constitute more than 50 per cent of the MSCI EM equity index, while the cyclical share is down to 20 per cent.”
Adrian Lowcock investment director at Architas, agrees that the developing world is no longer dependant on commodities, and that other areas are becoming more prevalent.
“The commodities super cycle clearly played a big role in the recent history of emerging markets with countries including Brazil and Russia benefiting from the massive demand from China, another emerging market. However there is more to emerging markets than commodities,” he said.
Performance of indices over 7yrs
Source: FE Analytics
“It is only natural that as the commodity super cycle has begun to wind down these other areas rise to prominence and fill the void.”
As a result, Dehn says the region is no longer cyclical, but has become a structural growth play, with the rise of technology a key part of this.
“The index ceased to be a cyclical commodity story some time ago as technology caught up with and now dominates commodities.”
As a result of this shift, he argues emerging market equities should be trading higher than their historical valuations and closing the gap on the developed world.
“As a structural growth play, EM equities should be closing the gap in valuations versus equities in developed economies. The fact that this has not yet happened suggests value in the asset class,” he said.
Performance of indices over 5yrs
Source: FE Analytics
Indeed, over a longer period (five years), emerging markets have been the worst performing of the major indices, and Lowcock says this is evidence that the region could be historically cheap compared to the developed world.
However, Lowcock remains cautious of other issues that may affect the developing world.
“Emerging markets are no doubt cheap, compared to their own history and indeed to other markets and although investors are becoming aware there is more to emerging markets than just commodities the sector continues to face a few challenges,” he said.
He notes that dollar strength remains an issue, with many companies owning dollar-denominated debt, while the perennial risk of a slowdown in China’s economy and investor risk aversion are all factors that may still weigh on emerging markets.
Ben Willis, head of research at Whitechurch, added: “Emerging markets are still heavily influenced by the US dollar (and therefore US interest rates and the US economy) and China. [Additionally] markets rally and retreat on the back of capital flows, and so whenever investors are nervous and seeking relative safer havens, capital is pulled from these markets and values fall, and vice-versa.”
So are emerging markets set for a sustained period of outperformance? Most agree to some extent, that while there are still headwinds, valuations are attractive.
Willis says this view may be valid over the long-term, but caveats that “people tend to have short memories” and whether or not investors will be able to shrug off the perception that emerging markets are cyclical remains its biggest challenge.
Adrian Lowcock said: “I agree emerging markets are looking more attractive. Valuations have fallen to levels not seen for a decade and the gap between emerging markets and developed market valuations are the highest they have been for a long time.”
“The issue is trying to predict when it will turnaround, 2016 might be the start of this but given we are still in the midst of the after effects of the financial crisis investors should be prepared to invest long term and be patient.”
Meanwhile, Simon Evan-Cook, senior investment manager at Premier, says it is too simplistic to draw broad brush strokes over the entire emerging market spectrum.
“We’re positive on emerging markets based on the valuation argument,” he said, but added that “some countries and companies have much better potential than others”.
He argues that despite a move to technology from commodities, not much has changed, with investor appetite remaining the decided factor.
“Nothing has majorly changed – it’s just what investors are focused on at any given time. At the start of the year the glass looked very half empty for emerging markets and half full for developed markets and it now seems to be switching back the other way. It’s a pendulum swinging and it seems to be swinging back to EM currently,” he said.
