The bear market that has blighted emerging markets for much of the recent past could be close to coming to an end and leaving the asset class looking to be attractively value, according to specialists in the area.
Emerging markets have underperformed the developed market-focused MSCI World index by a wide margin over the past decade, with the MSCI Emerging Markets index making a 161.58 per cent total return (in sterling). Meanwhile, the MSCI World is up by 212.87 per cent.
While emerging markets were strong in 2016 and 2017, last year proved to be another challenging one for the asset class – as shown by the chart below – as the stronger US dollar, the US-China trade spat and tighter monetary policy weighed on sentiment.
Performance of emerging markets vs developed markets in 2018
Source: FE Analytics
However, emerging markets have started 2019 with positive returns and Ashmore Group head of global research Jan Dehn said this is down to a handful of reasons.
“The pullback in 2018 created value and investors seem to be recognising this and are reducing their extremely large under-allocations to emerging markets accordingly. Aside from chasing ‘extra cheapness’, investors are also responding to the fact that the 2018 pullback was clearly temporary in nature,” he explained.
“The pullback was due to a dollar rally in response to stronger growth in H1 2018, the April 2018 hawkishness from the Fed, president Trump’s instigation of the China trade war in May as well as general profit-taking in non-dollar currencies after serious dollar weakness in 2017. All four drivers of the dollar in 2018 are now moving into reverse.”
Dehn added that investors should view just two developments of 2018 as having any semi-permanent implications for emerging markets: the Democrats gaining control of the US House of Representatives, as this makes the US government “a de facto lame duck in legislative terms”; and, the fact that costs are now eating into US company earnings for the first time since 2008/2009.
These factors mean that one of the of “the big four QE trades” – long US equities – is coming to an end. Two other QE trades – long dollar and shorting everything in emerging markets – went into reverse at the start of 2016 while the fourth trade – long European fixed income – will wane once European economic growth picks up.
GAM Investments investment director Tim Love, manager of the GAM Multistock Emerging Markets Equity fund, agreed that 2018 was yet another poor year for this asset class but expects investors to return to it over the coming months.
“2018 was a tumultuous year for emerging market equities, marking the fifth year of declines for the asset class within a decade,” he noted.
“And while 2019 could be a volatile year given the crowded political agenda ahead, with emerging market equities currently under-owned and looking, in our view, very reasonably valued vis-à-vis their developed market equity counterparts, we believe the asset class is likely to prove a popular investment option this year.”
Performance of emerging markets vs developed markets by calendar year
Source: FE Analytics
Love sees a number of factors will make emerging market investing more attractive over the course of 2019. While US-China trade tensions were a powerful catalyst for asset class’ declines last year, he argued that negotiations between the two countries are likely to bear fruit – even if they take some time – as the current situation is beneficial to neither.
Furthermore, the investment director said that any slowdown in the Federal Reserve’s interest rate hike programme would be a boon for emerging markets. Higher US rates have hit some emerging markets hard but investors could be encouraged to return to them if the Fed hikes slower than expected.
In addition to these external factors, he pointed out that the MSCI Emerging Markets index looks very attractive on valuation grounds. Its price/earnings ratio has fallen below 10x compared with 11.85x this time last year; he expects the emerging market P/E to re-rate upwards to around 14x in 2019.
“In our view, emerging market equities look very attractive – they are under-owned, undervalued and under-rated. We consider the relative risk/return profile of emerging markets versus that of developed markets to be favourable on the basis of the former's positive currency-adjusted returns,” he concluded.
Considering Love’s strategy exposure, he said that its overweight countries are currently Brazil and Russia.
Brazil is favoured as its economic backdrop is “very supportive” for the outlook for equities, in particular the newly elected pro-business government under right-wing populist Jair Bolsonaro.
GAM Investments likes Russia also for its economic backdrop, but caveats that the possibility of additional sanctions on the country needs to be watched.
Love is also overweight frontier markets through the ‘VARPs’ (Vietnam, Argentina, Romania and Pakistan). He is particularly constructive on Vietnam, which has benefitted from the US-China trade dispute, but sold down Pakistan after it was promoted to the MSCI Emerging Markets index.
Performance of developed, emerging markets and frontier markets over 10yrs
Source: FE Analytics
But emerging markets are regarded as one of the riskiest parts of the wider equity market and 2019 is not without its potential upsets, despite bullish sentiment.
“Emerging market markets are known for occasional spectacular sell-offs, usually in response to some debacle or other in a developed country,” Dehn said.
“However, emerging market markets can also stage truly vicious rallies, which can carry markets too far too fast. It is so easy to miss such rallies. It is inefficient that markets fall so far and rally so hard, but this is due to investor behaviour, because emerging market fundamentals are actually quite stable.
“While irritating, such inefficiencies do not undermine the case for investing, but they do call for tactical adjustment in exposures. If investors need to reduce their underweights in emerging markets then temporary pullbacks are the best possible time to do so.”