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How worried should you really be about holding emerging markets?

28 September 2016

Carlos Hardenberg, who heads up the Templeton Emerging Markets investment trust, explains why emerging market stocks have been pricing in an extreme crisis over the last year and how positive investors should really be on the sector at the moment.

By Lauren Mason,

Reporter, FE Trustnet

Despite a number of challenging headwinds on the horizon for emerging markets, overreactions have been priced into most metrics and there are still opportunities in the sector, according to Carlos Hardenberg.

The manager, who heads up the £1.9bn Templeton Emerging Markets investment trust, says that careful stock selection is nevertheless needed and investors should adopt a cautious approach to developing markets.

While low interest rates have driven a large number of investors into emerging market stocks and bonds recently, he points out that the net percentage of investors that are overweight emerging markets is still historically low when looked at over the last decade.

Performance of indices in 2016

 

Source: FE Analytics

“First of all, prices, country risk premia, currencies, stock markets and the default swap pricing within emerging markets have all been pricing in an extreme crisis level over the last 12 months,” Hardenberg said.

“It’s very much reflecting the fear of a pronounced, dramatic and prolonged slowdown of the Chinese economy. Concerns today are still very much about the property sector in China as well as overcapacity in many sectors such as steel and cement, which the world will have to deal with in the future. These are concerns which are not easy to overcome.”

While the MSCI Emerging Markets index has indeed rallied year-to-date, its performance has been lacklustre over the last five years due to fears surrounding China’s growth slowdown, the strengthening dollar and the ‘taper tantrum’ of 2013 when the Federal Reserve first hinted it would start reducing quantitative easing.

Despite the fact that emerging market stocks have optically rallied, Hardenberg says investors’ underweight position is understandable given the series of challenges the market area faces.

“It has been an environment which cannot be described any differently than a fearful environment in regard to US interest rates,” he continued.

“The Fed is expected to eventually tighten and, as these interest rates in the US increase, the big question is: what will happen to emerging markets? What will happen to asset prices in emerging markets? Will emerging market banks have to bear the costs of refinancing as these interest rates go up? Will returns should be affected by that?”

In this context, Hardenberg also says that currency impact should be taken into account by emerging market investors. He points out that the Brazilian real, the Mexican peso and the South African rand have all fallen by more than 50 per cent from their previous peaks compared to the US dollar.

While this has negatively impacted importing countries, the manager says this has also led to an increase in the competitiveness of local exporters within the emerging markets space.

For instance, he points out that 80 per cent of Mexico’s production is sold to the United States and, as the peso depreciated against the dollar, it became even more of an attractive market for the country.


At the same time, he argues this has partially led to an increase in costs in China, which is then likely to bruise its economy further. 

“The third big negative aspect that we’ve seen is the overall impact of the uncertainties related to the global supply and demand situation with commodity markets,” Hardenberg continued.

“If you look at the copper market as one example, the copper price is a good measure of sentiment in terms of global industrial development and it has adjusted dramatically.”

“The oil price, which is something that people are maybe more aware of … has adjusted by 60 to 70 per cent from its peak - although it has recovered a little bit it’s still very far below what it was previously.”

While commodity markets have been hit and impacted earnings in emerging and frontier markets, the manager says there is still an array of positive fundamentals that make emerging markets an attractive area to invest in over the long term.

He points out that markets tend to overreact when the general consensus is negative and, as such, prices become more volatile than the underlying earnings of companies.

“We’re seeing that industrial production is recovering across the entire emerging market space. Industrial production that has come down over five years – year-by-year – and for the first time, in the last six-to-eight months, it is seeing a robust recovery,” Hardenberg said.

“The second measure one needs to look at is the new industrial orders-to-inventory ratio. That one again is now, as of today, reaching a two and-a-half year high.”

“Of course the numbers are a little bit skewed because there’s quite a bit of augmentation from China, but if you go country by country, there’s a healthy degree of ordering on the industrial side taking place.”

What’s more, the manager says that local currencies across emerging markets are slowly recovering along with GDP growth.

Performance of currencies vs US dollar

 

Source: FE Analytics

Capex across many regions in the market area has been reduced due to an increased focus on cost management and, according to Hardenberg, this has led to an increase in earnings too.

“What we are excited about in emerging markets is where we see specific opportunities. Number one: you’re buying currencies still which are significantly cheaper than they used to be if you look at any time frame between five and seven years ago,” he explained.


“Number two: we’ve seen emerging market companies, especially in the mid- and small-cap arena and in some frontier markets, begin to look not only interesting from a valuation perspective but also from a business model perspective.”

“They’re embracing technology, they’re expanding business models into wider geographies so new export markets are being looked at, and this technology leapfrogging that’s taken place over the last few years is leading to very competitive business models which we think will outgrow those in more established markets in the future.”

As such and despite the headwinds that Hardenberg says need to be considered, he believes that investors’ underweight positioning, attractive valuations and the hunt for income could stand emerging markets in good stead over the longer term.

“We are expecting that emerging markets will see kind of a sideways development over the next 12 months. There are still clear risks regarding China and we are seeing that some of the economic recovery is already priced in to some degree,” he pointed out.

“Most upside is coming from currency and most of the potential upside will come from those companies which have the most competitive, most sustainable business models in emerging markets, of which we are finding most in Asia.”

 

The Templeton Emerging Markets investment trust, which Hardenberg co-runs alongside Mark Mobius, has fallen into the bottom decile over three and five years as it struggled during the down markets of 2013 and 2015.

That said, it is now in the top quartile over three, six and 12 months, having outperformed its sector average and benchmark by 17.85 and 8.9 percentage points respectively over the last year.

Performance of trust vs sector and benchmark over 1yr

 

Source: FE Analytics

Over the same time frame, it is in the top quartile for its Sharpe ratio (which measures risk-adjusted returns) but is in the bottom quartile for its annualised volatility and in the third quartile for its maximum drawdown (which measures the most potential money lost if bought and sold at the worst times).

Templeton Emerging Markets is trading on a 13.8 per cent discount, yields 1.4 per cent and has ongoing charges of 1.21 per cent. 

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