Emerging market investors should be keeping a close eye on the solidarity of the European Union as well as the impending US election, according to Hermes’ Gary Greenberg (pictured). 
The FE Alpha Manager, who heads up the five crown-rated Hermes Global Emerging Markets fund, believes that the recent rally of developing regions happened without enough positive fundamentals to warrant such behaviour.
However, he points out that economic foundations are now slowly starting to catch up with markets but warns there are a large number of uncertainties on the horizon for the sector.
Following five years of significant underperformance compared to other regional indices, MSCI Emerging Markets has rallied year-to-date due to dovish comments from the Federal Reserve, a recovery in commodity prices and political uncertainty in developed markets, while returns for UK investors have been flattered by the weak pound.
In 2016 so far, the index is up 39.02 per cent in sterling terms, comfortably doubling the returns of the FTSE 100 and the MSCI Europe ex UK indices.
Performance of indices in 2016
Source: FE Analytics
“We did say that we thought this would be a transitional year and emerging markets would outperform developed markets, which was right, I just didn’t think they would do so well,” Greenberg admitted.
“Brazil had a positive election result, that was part of it. The markets felt that the dollar was going to stay weak and that was part of it, which also manifested itself in a commodity rush. Then the markets discovered China was stimulating – which was happening last year but they discovered it this year – and then there was this rush into cyclical-type stocks.
“That really started in February when Janet Yellen spoke and she had just met with China who said ‘look, if you raise rates a lot right now we’re going to depreciate our currency so go ahead and see what happens’. So she didn’t.”
Recently though, the manager says the Federal Reserve has gradually become more hawkish due to increasingly positive economic data in the US.
As such, the dollar has now risen, the commodity trade has begun to slow down and global stimulus looks as though it will start tapering over the medium term.
“We went from a neutral environment at the very start of the year, to a frenzied low-quality rally from February through to August and now, although we’re higher in emerging markets, some of the fundamentals are starting to improve,” he said.
“Not enough to justify a huge rally from here, but enough to justify the rally that’s happened, ironically. Fundamentals are catching up with what happened for the wrong reasons.”
That said, Greenberg says there are geopolitical risks emerging market investors need to be wary of, chiefly the impending US election.
He warns that the market doesn’t seem to be factoring in a potential victory from controversial Republican candidate Donald Trump, which he says is likely to have a negative impact on emerging markets.
“[Trump] will be disruptive if he does what he says he wants to do, which is erect trade barriers. He could do on his own – there’s a view that he will be stopped by the institutions in America, but he can put them up himself,” the manager continued.
“Not to mention he can send troops – you don’t have to declare war to send troops. Yet, the VIX index [often known as Wall Street’s ‘fear gauge’] is at extremely low levels, implying no problem.”
Performance of index over 1yr
Source: FE Analytics
“It’s just like the propaganda we’ve had in this country saying that Brexit is no problem. The market went up, everyone is still employed, so what’s the problem? It takes more than a few weeks and it’s taking that and applying it to the US election.
“As long as this illusion that the Fed exists to keep the market going higher persists, the complacency will remain. Then again, we have four weeks to see about that.”
Another potential headwind that emerging market investors should consider, according to Greenberg, is ironically one of the reasons investors have been moving away from the UK and Europe into emerging markets in the first place.
The manager believes that the UK’s vote for Brexit could encourage the popularity of anti-European movements across the rest of the European Union, which is also likely to have a negative impact on emerging markets if the union were to dissolve.
“The second big unknown is the European break-up, which is a risk and it’s very difficult to discount that. We have elections in France and Germany next year and a referendum in Italy, among others,” he said.
“If you have a move towards anti-European and anti-immigrant governments, then you have the potential break-up of the eurozone which is a big deal.
“It’s really hard to discount exactly what the repercussions of that would be. But, if you think about it, it would probably mean southern European currencies would go down a lot – they would reset, so to speak.”
Greenberg says that, given sterling’s sudden fall after the EU referendum results were announced, a 20 per cent drop in currencies across Europe is plausible and the products they manufacture would therefore compete with products made in emerging markets.
Performance of sterling vs US dollar after referendum results
Source: FE Analytics
He also says that European countries would compete with emerging markets in non-tradable sectors such as tourism.
“Italy, since 1992, has grown their per capita income on a total basis – not per year – by 5 per cent. It’s a failure,” the manager explained.
“If you talk to anybody my age about their kids who live there they don’t have jobs, unless they move to London. It’s just impossible.”
“Okay Spain has a little bit of a recovery but unemployment in Greece still remains gargantuan. I’m just not sure how long people are going to take it. It’s been good for Germany but southern Europe is really suffering, so my guess is they will go back to having their own exchange rate in a few years so they can depreciate it and gain some competitiveness that way.”
Other headwinds that Gary says need to be considered within emerging markets include the Chinese banking system and its high number of bad loans, instability in Turkey and strained relations between Russia and the US.
That said, he points out that a greater focus on corporate governance, a shift towards technological manufacturing and stronger economic data are all positives for many areas within emerging markets.
“Okay, European elections can go the right way or the wrong way but that won’t happen with immediate effect,” Greenberg continued.
“I think the base case is for things to gradually and gently improve.”
Over Greenberg’s tenure, the £859m Hermes Emerging Markets fund has returned 45.98 per cent, more than doubling the performance of its sector average and MSCI Emerging Markets benchmark over this time frame.
Performance of fund vs sector and benchmark under Greenberg
Source: FE Analytics
It is also in the top quartile for its Sharpe ratio (which measures risk-adjusted returns), maximum drawdown (which measures the most potential money lost if bought and sold at the worst possible times) and downside risk (which predicts the fund’s likelihood to fall during negative market conditions) over the same time frame.
Hermes Emerging Markets has a clean ongoing charges figure of 1.14 per cent.