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Four reasons why 2016’s best performing sector will keep rallying

15 September 2016

Natixis’ David Lafferty explains that risks surrounding emerging markets at the start of the year have eased and do not look likely to come back in the short-to-medium term.

By Jonathan Jones,

Reporter, FE Trustnet

Emerging markets have had a dramatic return to favour in 2016 and David Lafferty, chief market strategist at Natixis, suggests the four major risks worrying investors could now be over – at least in the short term.

The strategist says he was optimistic on emerging markets before the rise seen this year and notes that while this has taken some of the shine off the sector, he would still invest in developing world equities over the longer term.

So far this year, emerging markets have risen 26.42 per cent in sterling terms due to various factors such as issues facing the developed world.

Performance of indices in 2016

 

Source: FE Analytics

As the above graph shows, the MSCI Emerging Markets has been the best performer this year, beating the likes of the S&P 500 by 8.14 percentage points and the UK’s FTSE 100 by 15.57 percentage points.

Lafferty said: “We were optimistic last year because they [emerging markets] had underperformed international developed markets for about three and a half years and underperformed the US market for five and a half years so it was almost a pure mean reversion outlook.”

He adds that valuations were also cheap with the MSCI Emerging Markets index on multiples of around 10 to 12 times earnings at the end of last year.

“So mean reversion and cheapness meant I took a flier and said I thought this would be the year emerging markets would do well and it’s been brilliant so far,” he said.

However, this has not been the case for much of the market’s recent history, with emerging markets underperforming for the five years prior to this year as dollar strength, China’s woes, falling commodity prices and uncertainty surrounding the future of US interest rates all weighed on sentiment.

Performance of indices over 5yrs to the start of 2016

 

Source: FE Analytics

Over this period, emerging markets made a paltry 1.82 per cent, 33.73 percentage points below the next worst performing region – Europe – and far behind the 119.39 per cent return seen by the S&P 500.


“I think there were four risks that have been prevalent over the five years that emerging markets have underperformed and I think all were justified.”

He pinpoints these as the slowing of the Chinese economy, the effect this has on the other domestic economics within the emerging market, the commodity price drop and the ‘dollar funding crisis’ or the debt deleveraging crisis.

“I think the market was looking at all four of those and saying –China’s slowing, commodities are falling and the dollar is rising – this is not a good scenario for emerging markets,” he said.

“But at the end of last year all four of those factors seemed to be bottoming.”

He says concerns over the Chinese economy seem to have eased, with the economy appearing to bottom out at the start of the year.

Lafferty, however, says this may still be a risk further down the line.

“[However] I don’t think it’s one that emerging markets should be really focused on right now,” he added.

This has eased the concerns of the first two major risk factors surrounding emerging markets, while commodity prices have also rebounded.

 “The commodity bust has sort of bottomed – oil has started to go back up – and other commodities are not falling anymore.”

Performance of indices over 3yrs

 

Source: FE Analytics

Indeed, as the graph above shows, commodity prices slumped until earlier this year, with oil and gold notably dropping at the beginning and end of 2015.


However, both have rebounded since February, with the S&P GSCI Commodity Spot index now up 14.49 per cent since the start of the year.

As well as this, the Federal Reserve has been (so far) unwilling to raise interest rates this year, following their rise to 0.5 per cent at the end of 2015.

While many at the time thought it likely that the Fed would raise rates incrementally over the course of 2016, none have yet materialised.

Lafferty caveats that the only remaining issue that may cause a problem to the emerging markets is if the Fed does raise rates this year, as many, including himself, expect in December.

“I still think – and you saw this on Friday – of these risks the one that always seems to derail emerging markets on a daily or weekly basis is the dollar funding. It always seems that hawkish talk from the Fed is what derails it because China and commodities are moving a bit more slowly but the Fed impact can happen very quickly.”

“One odd word from a Fed member can upset emerging market equities if they think it’s indicative of tighter policy.”

However, Lafferty says that at the start of the year, all these factors were priced in, with valuations on the MSCI Emerging Markets index around 10 times earnings.

This has now risen to around 14 times earnings, but Lafferty says he is still keen on emerging markets over the longer term.

“We still like emerging markets over the long run because it’s the only place you don’t have a secular growth problem – it’s still the best place for organic growth – they’re [stocks] just not as cheap as they used to be,” he said.

“So if you ask ‘do you like emerging markets through the rest of the cycle’ the answer is yes I just don’t like it as much as when it was 40 per cent cheaper six months ago.”

 

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