A recent poll of investment trust managers found that 23 per cent of the industry were backing emerging markets to outperform in 2018, placing it second behind Europe as the sector they were most optimistic about for next year. But with several challenges facing emerging markets next year, why are so many managers bullish?
The MSCI Emerging Markets index is up 23.3 per cent this year, which followed a gain of 32.63 per cent in 2016.
Performance of indices since start of 2016
Source: FE Analytics
However, Nick Price, manager of the Fidelity Emerging Markets fund, pointed out that this rally started from a very low base – the index fell 10.65 per cent in the three years to the start of 2016 – and said there are numerous reasons why the rebound can gather momentum.
“The impressive run in 2017 was set against a backdrop of better economic data, less pronounced dollar strength, stronger local currencies and more robust commodity prices. These factors have helped to restore confidence,” he explained.
Price (pictured right) said that policy developments across the major economies of the developing world also bode well. In India, for example, prime minister Narendra Modi’s reform agenda continues to progress, while the manager has been encouraged by numerous aspects of government policy in China, citing environmental and state-owned enterprise reform among the areas to watch.
“The implementation of bold changes should drive greater economic stability over the medium to long term,” he continued.
“More broadly, measures to address housing issues in India – under the banner of ‘housing for all’ – and far-reaching healthcare reforms in China can provide us as stockpickers with multi-year growth opportunities.”
James Donald, manager of the Lazard Emerging Markets fund, said that despite the rally, the sector still looks relatively cheap.
While valuations have moved higher since early 2016, emerging market equities still trade at a discount to their developed counterparts, while also offering comparable or better return on equity and dividend yield figures, in some cases.
This is a view echoed by Carlos Hardenberg (pictured left), manager of the Templeton Emerging Markets Investment Trust.
“We see better visibility in emerging market companies’ earnings forecasts and believe that earnings still have a lot of room to recover,” he said. “Putting all these factors together, we consider the valuations of emerging market companies as of late 2017 to still be very attractive.”
However, he warned there may be volatility ahead as investment flows often reflect attitudes to perceived risk – there tend to be inflows as investors move “risk-on” and outflows as they move “risk-off” in outlook.
“Less mature markets tend to be heavily sentiment-driven, and so share prices in those markets could quickly reflect any scepticism,” he continued. “Even so, major global investors have a lower proportion of exposure to the asset class, below what we would expect given the proportion of global GDP and market capitalisation that emerging markets represent, and that could support continued inflows.”
Wavering sentiment is far from the only potential headwind for the sector – Jan Dehn, head of research at emerging markets asset manager Ashmore Group, noted that there will be important elections across the developed world next year – most notably in Mexico and Brazil – which tend to cause large amounts of volatility. However, he said this should give cause for active managers to “rejoice”.
“The run-up to elections is almost always characterised by serious mispricing of assets as the implications of different election outcomes are taken to unreasonable extremes,” he explained.
“This creates major alpha generation opportunities in most cases.”
The threat to emerging markets that has most investors worried is the tightening of monetary policy in the US. The Federal Reserve has hiked rates four times since the start of 2016 and is expected to raise them by two or three times in 2018.
Previous tightening cycles have seen investors pull money from riskier areas such as emerging markets as the return from cash in the US becomes more attractive, while any debt priced in dollars becomes more difficult to service as the currency strengthens. This was seen in the “taper tantrum” of 2013, when the Federal Reserve’s decision to begin reducing its asset purchase programme led to the sector making double-digit losses over three years.
However, Jorry Rask Nøddekær, manager of the Nordea 1 Emerging Stars Equity fund, said emerging market economies are now in a much better position to cope with further US tightening.
“We must assume the Fed will only act if it sees acceleration in the economic growth outlook, which will be good for emerging markets,” he explained.
“From a capital flow perspective, we see current account balances, equity valuations, earnings-per-share growth differentials between emerging markets and developed markets and the interest yield differential being at such levels that there should not be major pressure on emerging markets when the Fed takes action.
“Furthermore, the US dollar debt funding situation in emerging markets is very different today in comparison to 2013. However, we do acknowledge that investors may seek to reduce emerging market exposures as the Fed tightens policy. This will likely be a short-term dynamic, as investors recognise they are betting against fundamentals.”
Hartwig Kos (pictured right), chief investment officer and co-head of multi-asset at SYZ Asset Management, added that while emerging market debt in particular is the asset class that comes to mind as most vulnerable when the US raises rates, many of the most exposed nations have undertaken reforms to “reduce external vulnerabilities”.
“Moreover, relative valuations among fixed income markets are much more tilted in favour of emerging market assets than in the past,” he said.
“Given the frothiness in global high yield valuations, one could even see emerging market debt as a relative safe haven, regardless of what the Federal Reserve is going to do.
“When it comes to emerging equities, it is probably not the rising rate trajectory of the Fed that has the power to bring the gravy train to a halt. There have been instances in the past, such as the period from 2004 to 2006, where the Federal Reserve raised interest rates substantially yet emerging markets continued to steam on.”