Emerging market equities are undergoing a recovery that is so strong investors should consider any short-term volatility as an opportunity to add to exposure rather than flee to safe havens.
That’s the view of Ashmore Group’s head of research Jan Dehn, who believes that any pullbacks in emerging markets – such as those seen in recent weeks – are “inevitable and ultimately very healthy” but are also likely to be short-lived.
Meanwhile, Psigma Investment Management head of investment strategy Rory McPherson thinks that emerging markets still offer some of the best regional opportunities for value despite their recovery over the past year or so.
Emerging markets have been on a strong run over 2017 to date. FE Analytics shows that the MSCI Emerging Markets index has posted a total return of close to 21 per cent since the start of the year and outpaced the developed market-focused MSCI World by more than 12 percentage points.
However, emerging markets have typically given investors a rougher ride than the developed world. The MSCI Emerging Markets index’s annualised volatility over 2017 has been 10.56 per cent with a maximum drawdown of 4.34 per cent; for the MSCI World, annualised volatility was 6.71 per cent while the maximum drawdown has been just 1.92 per cent.
Performance of indices over 2017 to date
Source: FE Analytics
As the chart above shows, emerging market equities were hit with a relatively large pullback during September but Dehn argued that this should not be seen as a reason to sell out but as an opportunity.
“Last week a bout of volatility afflicted a number of global markets, including emerging markets. Such events should be ruthlessly exploited to buy into emerging markets, in our view,” he said.
“A strong emerging markets recovery is underway, which is backed by valuations, technicals and fundamentals. Investors who do not yet have exposure should use such opportunities to allocate, because they are unlikely to get better opportunities to buy than in such temporary pullbacks.”
Dehn noted that last week’s currency and bond market volatility was triggered by events “entirely exogenous” to emerging markets themselves. The prospect of a Trump tax cut suddenly boosted hopes of stronger US growth. Expectations of fiscal stimulus forced yields higher for US Treasury bonds, in turn helping to price in a December Fed hike. This enabled the Fed to sound hawkish by signalling an intention to hike in December.
Furthermore, euro pessimism re-emerged due to German chancellor Angela Merkel’s poorer than expected result in the recent general election and the market appeared to completely ignore French president Emmanuel Macron’s recent strong commitment to meaningful European reform.
Dehn pointed out that that there are five factors behind the recent emerging market but added that there are reasons to believe none of them will have a long-lasting negative effect on the emerging market recovery.
US tax reform, if it ever takes place, is likely to be modest in size due to constraints on funding owing to the failure to repeal Obamacare. In addition, the cut is likely to act like a fiscal stimulus, which would push the lower long-term equilibrium interest rate lower and thus support a lower Fed funds rate – which would not be harmful to emerging markets.
The second factor – a December interest rate hike by the Federal Reserve – is almost fully priced into markets and the central bank is likely to want to avoid hinting at any rate increases after this in a bid to keep both markets and the economy calm, the head of research said.
Performance of indices over 8yrs
Source: FE Analytics
Sentiment towards Europe has a good chance of improving as Merkel forms her government and begins to work with Macron on reforms, although the Catalan referendum will probably lead to some market jitters in the short term.
Further to this, the European economy continues to look solid, suggesting that European Central Bank will continue to slowly move towards tapering of its stimulus programme.
Finally, Dehn argued that the broader backdrop of unwinding quantitative easing trades remains intact and technicals, fundamentals and valuations all “strongly favour” emerging markets being a key beneficiary of this. As the chart above shows, emerging markets have lagged the MSCI World over the eight years that quantitative easing (QE) has boosted markets.
“In conclusion, the pullback in markets last week is the pause that refreshes,” he said.
“These inevitable bouts of volatility are excellent opportunities to leg into the big trades, which will dominate financial markets in the next few years, including long euro versus US dollar, long US bonds versus European bonds, long European equities versus US equities and, above all, long the non-QE markets, including emerging markets FX, equities and local bonds versus the QE-sponsored markets.”
Over at Psigma Investment Management, McPherson highlights the relative value still being offered by emerging markets. Despite a 20 per cent total return year-to-date, they are still more than 60 percentage points behind developed market stocks on a three-year view and still tend to be underweighted by investors.
“Emerging market stocks are currently attractive, not least because of their valuations. At a forward P/E multiple of circa 12.6x, they are trading at a marked discount to their developed market counterparts which trade on a more full 16x multiple of next years’ earnings,” he said.
“In addition to this, emerging markets are enjoying extremely strong earnings growth (expected to run at 20 per cent this year) combined with the virtuous kicker of rising profit margins. This earnings growth is especially pronounced within the Asia region which is our preferred area. Value alone is not enough for us, but combine it with improving business cycles along with the fact it’s under-owned and it gets our contrarian juices flowing.”
Performance of funds vs index over 2017 to date
Source: FE Analytics
Within emerging markets, Psigma prefers Asia – which accounts for around 70 per cent of the MSCI Emerging Markets index. McPherson pointed out that Asia is experiencing high levels of economic growth, is seeing policy being eased and tends to import commodities, thereby benefitting from low prices.
He highlighted two funds as being the firm’s preferred means of access: BlackRock GF Asian Growth Leaders and Macquarie Asian All Stars.
Andrew Swan and Emily Dong’s $2.9bn BlackRock GF Asian Growth Leaders fund has returned 99.7 per cent since its launch in November 2012, compared with a 56.46 per cent return from MSCI AC Asia ex Japan index. The style-agnostic portfolio is currently overweight areas such as energy, materials and financials, with an underweight to information technology.
Macquarie Asian All Stars, which is managed by John Bugg, Sam Le Cornu and Duke Lo, has made 27.85 per cent since launch in November 2014, slightly underperforming the MSCI AC Asia ex Japan index. Its core investment thesis for 2017 is consumption growth and this is reflected in overweights to high quality companies in the consumer discretionary and consumer staples sectors.
BlackRock GF Asian Growth Leaders has an ongoing charges figure (OCF) of 1.10 per cent while the Luxembourg-domiciled Macquarie Asian All Stars fund’s annual management charge is 1.65 per cent.