The potential break-up of the European Union could harm emerging market equities via a double-edged sword of negative real growth and news of an international crisis, warns Lazard’s James Donald (pictured). 
The manager of the £1.1bn Lazard Emerging Markets fund also says protectionist policies from Trump could bruise emerging markets, as well as a strengthening dollar which could occur as a result of rate hikes.
That said, he is positive in terms of finding new investment opportunities this year and believes that 2017 is the ‘make-or-break’ year as to whether value stocks continue to rally versus quality growth stocks.
“In 2015, we saw relatively expensive stocks outperforming relatively cheap stocks and that is not always the case. Last year, it was mixed,” Donald said.
“Some people would say it was a value year but I would say it was a mixture. Value certainly did relatively better but I don’t think it was a case of real value because, on valuation charts, it didn’t steadily rise and it wasn’t the case of the cheapest stocks outperforming and the most expensive stocks underperforming. It was a mixed bag.
“Markets are trying to find direction right now. Either we go back to that pre-2015 period when the expensive defensives lead the market. Or we go into a fully-fledged value market.
“I think what it depends on is whether capital markets have completely discounted deflationary pressure. That is the key question and I only have ideas about that, we’ll have to see. I think this year that will be determined.”
Performance of indices over 3yrs
Source: FE Analytics
One of the key reasons value began to outperform during the second half of last year was the election of US president Donald Trump, whose proposed infrastructure spending was believed to lead to inflation, a boost in growth and potential rate hikes from the Federal Reserve.
While this has been good news for the US equity market, investors have been more cautious on emerging markets – for the most part, last year’s ‘darling’ sector – given a potential rise in the US dollar and the fact that many countries in the region hold dollar-denominated debt on their balance sheets.
“Investors are concerned about interest rates rising in the US and the dollar. However, during four out of the last five times that short-term interest rates have risen in the US, we’ve actually seen a plateau of the dollar within around six months,” Donald pointed out.
“I’m a little more optimistic about the dollar flattening out and maybe even starting to decline a little going forwards. Clearly if the dollar kept on rising that would bring pressure on emerging markets, and especially for some of the markets in particular.”
The manager’s biggest concern when it comes to Trump is if his policies are as protectionist as his election campaign implied. While he believes this is unlikely, he warns that it should be highlighted as a significant potential risk to the market area.
“Our biggest concern with Donald Trump is if he was truly protectionist. I think if he put in true protectionist measures that would be negative for emerging markets and I think it would be negative for the US. It could bring about stagflation globally, which would not be a good situation at all,” he continued.
Donald says the other potential headwind for emerging markets this year could be a break-up of the EU, which could become more of a concern depending on the election results in France, Germany and Holland later this year.
While this may seem uncorrelated to the health of emerging markets, the manager explains that a combination of negative real growth and news of an international crisis could bruise the sector. 
This sentiment has been shared by other emerging market managers over recent months. In an article published last October, FE Alpha Manager Gary Greenberg – who heads up the five crown-rated Hermes Global Emerging Markets fund – told FE Trustnet an EU break-up shouldn’t be discounted given the recent rise of populism across developed markets.
“It’s really hard to discount exactly what the repercussions of [an EU break-up] 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,” he said.
The manager also warned that, if currencies were to fall 20 per cent as sterling did after the EU referendum, the products that southern European countries manufacture would therefore compete with products made in emerging markets.
Donald says that an EU break-up would negatively impact all markets globally as well as just emerging markets.
However, while he says this risk shouldn’t be dismissed, he believes it is unlikely that France and European powerhouse Germany would experience a majority vote for an anti-EU leader.
“If we have a president La Penne or if Merkel lost, it would be pretty important for markets,” he explained.
“Our French colleagues seem very confident that, regardless of who faces Marine La Penne in the final round, if needs be they’ll hold their nose and vote against her.
“With Merkel, it sounds as though there’s an understanding with the socialists that, if it really gets to a stage where she can’t win, that there might be a coalition even with the socialists for the sake of national unity.
“I can’t quite imagine Germany or France voting to crack up the EU because, at the end of the day, they are the partnership that, to a large extent, founded and secured the EU over its life. They would be the last two countries in the world that would finish it off but, again, this has been a period of surprise. I think we have to talk about it at the very least.”
In terms of finding portfolio opportunities this year though, Donald – who adopts a relative value approach to stock selection – is positive and sees significant upside to the target prices his team are anticipating.
Performance of indices over 15yrs
Source: FE Analytics
While he says the asset class isn’t undervalued relative to history, he points out that no asset class seems cheap right now and that, compared to developed market equities, emerging market equities are trading on a 30 per cent relative discount compared to the last 15 years.
While the manager adopts a predominantly bottom-up approach to choosing stocks, he also makes use of a macro overlay to minimise any major portfolio risks. As such, he remains wary of the potential impact a break-up of the EU could have on emerging market equities and indeed his portfolio.
“In 2011 we had a growth scare over sovereign debt in Europe and that had a major influence on the emerging markets. Emerging markets, because of their higher levels of volatility, may not have anything to do with where a crisis emanates from but could still be impacted,” he concluded.
“We have to be aware of issues outside of our world because we’re very interlinked. The perfect environment for emerging markets is balanced growth and positive real growth. It doesn’t necessarily have to be extremely strong but, if it’s positive and we don’t have crises, it’s usually a very good backdrop for emerging markets.”
Since 2000 (which is as far back as our data on the fund stretches), Lazard Emerging Markets – launched by Donald in 1997 – has returned 499.61 per cent compared to its average peer’s return of 365.15 per cent. It has also comfortably outperformed its sector average over one, three, five and 10 years.
Performance of fund vs sector and benchmark since 2000
Source: FE Analytics
While the £1.1bn fund is benchmark-agnostic, it should be noted that the fund outperformed the rallying MSCI Emerging Markets index by 13.57 percentage points in 2016 with a return of 46.2 per cent. This meant it was the third-best performer in the sector.
Lazard Emerging Markets has a clean ongoing charges figure of 1.06 per cent and yields 2.1 per cent.