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Neptune: There is still plenty of upside in emerging markets from here

07 August 2017

Neptune Investment Management’s emerging market fund managers outline why the sector could be set for continued outperformance in the coming years.

By Jonathan Jones,

Reporter, FE Trustnet

Emerging markets have faced a number of challenges over the past five years or so, but the tide may be turning in the sector’s favour, according to several of Neptune Investment Management’s specialist fund managers.

The asset class has outperformed its developed counterpart over the past year and experienced the strongest first quarter for five years, yet it remains cheap relative to developed markets and on an absolute basis.

Robin Geffen, Neptune chief executive and fund manager, noted: “Not for a number of years have we seen an improving growth story happening simultaneously in the emerging and developed worlds. It’s a great backdrop for an asset class that is attractively valued.

“So far, the move into emerging markets has been positive, but we think there is plenty of room for upside from here in a number of different areas.”

Emerging markets have been on a strong run over the past year, having disappointed for many years since the financial crisis, lagging the developed world by 40 percentage points over 10 years.

The outlook has improved over the past 12 months, the MSCI Emerging Markets index has returned 25.43 per cent compared to 18.26 per cent from the MSCI World index, as the below chart shows.

Performance of indices over 1yr

 

Source: FE Analytics

However, investors have been burned by a number of false dawns in emerging markets over recent years as hopes of an economic turnaround have often been snuffed out by commodity price drops or shifts in market sentiment.

As such, below Neptune fund managers explain what has driven performance of emerging markets in recent months.

The first key driver has been the improving macroeconomic environment. Despite having languished under a deflationary environment, slower global growth and weak PMIs from key importers in recent years, emerging markets rebounded last year as these trends began to reverse.


“Now we are seeing the effect of these headwinds turning into tailwinds,” the Neptune managers noted.

“Emerging market equities have just had their strongest first quarter since 2012, PMIs have been increasingly strong and growth prospects are improving.

“In our view it is clear that emerging markets are in the early stages of a cyclical recovery.”

Neptune Emerging Markets manager Ewan Thompson rotated his portfolio to take advantage of this changing economic climate last year.

Having been firmly focused on defensive, domestic-driven stocks up until 2015, Thompson rotated towards value last year.

“The conditions which suited a quality-biased fund are now changing rapidly, which just goes to show how flexible you need to be when it comes to emerging markets,” the manager said.

“To us the backdrop is ideal for cyclicals; stabilising and increasing global growth, a Chinese ‘hard-landing’ off the table and commodity price rises driving inflation,” he said.

Performance of indices over 3yrs

 

Source: FE Analytics

This benefited the £11m, five crown-rated fund, which is in the top quartile of the IA Global Emerging Markets sector over three years and ahead of its benchmark and sector over two.

As well as an improving macroeconomic backdrop, the Neptune emerging markets team highlighted strengthening company earnings.


“The earnings outlook for emerging markets has greatly improved, supported by improving corporate governance and political reform – though there is still work to be done,” they noted.

This is particularly apparent in India, where reforms made by president Narendra Modi including new taxes and demonetisation have benefited the economy and the market.

Neptune India Fund manager Kunal Desai (pictured) said: “We have seen big moves across the emerging markets but the key to these returns becoming sustainable is the earnings recovery story, something we’ve been talking about in India in particular for a long time. 

“We are at an inflection point, where you are seeing demand picking up, using up this excess capacity, whilst companies are continuing to show balance sheet restraint. That’s the real cash flow sweet spot.”

Yet, despite the fact that earnings growth in emerging markets is forecast to grow at 17-18 per cent over the next year, Thompson said valuations remain at around the same level they were last year. 

“With earnings upgrades coming through, we expect to see a re-rating in equity markets,” the manager said.

“Emerging markets are still trading at a significant discount of around 30 per cent to developed markets and to us this makes them look very good value indeed.

“The scale of the opportunity should not be underestimated by investors. Given the depth that valuations sunk to thanks to such a protracted period of underperformance, there is plenty of spring in the market.”

As well as earnings growth, many of the largest countries in the region such as China and India have also become more economically and politically stable in recent years.

“Emerging market businesses were awkwardly positioned for a slowdown in global growth in 2010; they had binged on capacity expansion and were suddenly faced with an excess capacity hangover,” the managers said.

“Thanks to a broad capacity cutting program – particularly in the commodities sector – prices are stabilising.

“Chinese initiatives to steer the economy away from a ‘hard-landing’ by supporting the housing market have also increased demand for raw materials, iron ore in particular.”

Five years of low growth have forced these economies to employ longer-term strategic initiatives to improve their business climates, and Thompson said investors can now see better corporate governance, falling current account deficits and government reform programmes all over the emerging markets.

“The key overweights in the emerging market funds are in the economies that are pursuing pro-reform agendas, from Modi’s modernisation of India to Russia’s commitment to becoming a top 20 World Bank ‘Doing Business’ economy by 2020.”


However, challenges still remain, with the most obvious in Brazil, where after showing much promise, president Michel Temer is under investigation for corruption.

“While the long-term growth prospects for emerging markets are attractive, the nature of the asset class means that investors always need to be wary of downside risks,” the Neptune investment team noted.

“Corporate governance and political reform have been a bright spot in emerging markets of late, but one area with less positive newsflow in recent days has been Brazil.”

Yet, even here, Thomas Smith, manager of the Neptune Latin America fund, believes there are investment opportunities in one of last year’s best performing markets in the region.

“The move in the market after the news broke suggests investors are pricing in zero chance of further reforms,” he said.

Indeed, as the below chart shows, the MSCI Brazil index plummeted 16.88 per cent in May as allegations of corruption became public.

Performance of index over 3yrs

 

Source: FE Analytics

Since then the economy has recovered, however, and is up 9.86 per cent year-to-date, but Smith said it is too early to tell what impact it will have in the long-term.

“While these allegations are likely to delay the reform agenda, it remains a key priority for Temer, and we believe this will be the case for the new government should he leave,” he said.

“The growth prospects for Latin America are very encouraging, but as with any emerging economy you have to be cognisant of the potential for short-term blips, that is why we focus on downside protection by maintaining a diversified portfolio,” he added.

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