Emerging markets were the surprise package of 2016, struggling early on due to concerns over a potential slowdown in China before ending the year as one of the best performing sectors.
While the election of Donald Trump as US president has led to concerns that the sector will fall back this year, Carlos Hardenberg, manager of the Templeton Emerging Markets trust, says developing economies are now in general more defensive and less vulnerable than they have been at any time in the past.
Last year, the MSCI Emerging Markets index returned 32.61 per cent compared with 28.24 per cent from the MSCI World index – a proxy for developed markets.
Performance of indices in 2016
Source: FE Analytics
Despite the turnaround in fortunes many remain concerned that the emerging markets are a risky proposition that caught a tailwind of rising commodity prices and developed market uncertainty.
However, Hardenberg says now is the time to buy into the emerging markets if previous market cycles are an indication to go by.
“If you study the history of the markets in most cases the biggest opportunity to invest is when currencies come under stress and are oversold and surely last year was one of those periods,” he said.
“Currencies in all emerging markets got sold down dramatically and markets overreacted in places like South Africa, Brazil, Russia and others.
“Yes there has been a period of recovery but nevertheless we are still seeing that on a purchasing power model we still see that there is value in these emerging market currencies.
“Some of the effects we have seen coming from the depreciation of local currencies and the economic adjustment as a reaction to a slowdown in the emerging markets there has been a good degree of import substitution and as a result of that the current accounts and the balances look much better than they used to.”
As a result, he says emerging markets are “more defensive and less vulnerable” than they have ever been.
The big argument against this, he says, is a rising US dollar, which increases the cost of dollar-denominated debt, however, the trust manager says this is less of a problem than it has been during previous crises.
“I think it’s a fair statement to say that even if the dollar appreciates further – and while it is not appreciating right now that is the general expectation – the threat on emerging market economies is mitigated by the fact that current account balances look so much better than they used to.”
As well as currency effects, he says higher earnings and lower debt have made companies much more attractive than in previous cycles.
“The one that is quite well flagged and understood by investors but can’t be underestimated is the impact of lower debt.
“The lower debt compared to the developed markets is not only very visible on the governments who have deleveraged but also on the corporate sector which has deleveraged significantly so the corporate balance sheets have a lot less in US dollar debt and they have used more local instruments, moved into more local currency debt which is a defensive measure.
“But overall the debt hasn’t really increased very much so they used the good years to deleverage as if they were expecting more difficult times ahead. In comparison the developed markets look much more vulnerable.”
As well as this, a rebound in commodity prices, which he says now sit at sustainable valuations have improved the prospects for the emerging markets.
Performance of index over 10yrs
Source: FE Analytics
As the above graph shows, commodity prices spiked during the financial crisis in 2008 and began rising again through to 2011 but since then have fallen back and particularly eased in 2014 and 2015.
“If we look at some of the commodity prices – of course one of the reasons we had a crisis in the emerging markets was the very steep fall in commodity prices.
“The important part of the message is that we would expect much less volatility from here as there was this phase where commodity prices were brought up by speculators and hedge funds and other market participants to levels that were unsustainable.
“We see that right now the prices are much more reasonable and most importantly, these are prices where most emerging market companies are able to not only make a good margin but have a better ability to plan their business going forward.”
However, not all are convinced, and Liontrust global equity fund manager Patrick Cadell says Donald Trump (pictured) in particular could pose a big threat to the emerging markets.
“There are a number of substantial risks that I do not believe are outwardly discounted in asset prices at the moment and there is a degree of investor complacency around these risks,” he said.
He cites Mexico which has borne the brunt of Donald Trump’s protectionist call and Turkey, which is currently suffering from an acute dollar shortage and has had to increase interest rates significantly to stabilise the FX market, as examples of countries already affected by the new US president.
One potential policy that could pose the biggest headache to emerging markets is the border adjustment tax.
“Now as protectionist, nationalistic, disruptive and outright insane as a border adjustment tax is, it’s not even a Donald Trump idea. The border adjustment tax idea belongs to Paul Ryan and the Republican congress. They see it as a way to fund Trump’s tax cuts and infrastructure spend.
“The impact would be – it would lead to a much stronger US dollar, it would lead to higher US interest rates and it would disadvantage countries and companies that export to the US.”
However, as the bill is currently going through congress and will likely to take several months to pass, there is also one area concerning him immediately – foreign direct investment (FDI)
“An area we are seeing an impact from Donald Trump in 2017 and it should be very worrying for investors is foreign direct investment.
“FDI at its simplest is a company building a plant or making an acquisition in a foreign country. It is however the lifeblood of emerging markets. It was responsible for the Asian tigers in the 1990s and the commodity boom of the 2000s.
“It is an incredibly important determinant of future GDP growth because FDI is how new manufacturing technologies and processes find their way to emerging markets. It boosts growth, it boosts productivity and it establishes the global supply chains that lead to future trade routes.
“As a result if it is removed or reduced the potential GDP growth of a number of countries diminishes and we are seeing FDI delayed or cancelled due to Donald Trump.
“We’ve seen companies postpone or cancel building plants in Mexico. We’re seeing electronic giants decide not to build their next electronics plant in Vietnam but actually in the USA. This is all very negative for emerging markets.”