Emerging markets still offer good value but investors should prepare for more volatility and lower returns in 2018 than they saw last year, according to Schroders fund manager Philip Chandler.
The manager, who works within the multi-asset team, said 2017 was fantastic for investors as returns from equities were strong across the board while volatility remained low.
In the US for example, the S&P 500 registered a positive return in each discrete month of the year, as the below chart shows.
Performance of index over 13 months
Source: FE Analytics
As such, Chandler said the Sharpe ratio – which measures risk-adjusted returns – for most asset classes looked very good last year.
“I think that the big factors that drove returns last year were cyclical,” he added, rather than valuations, which were not cheap at the start of the year but remained unconcerned.
“Valuations are slightly rich but the big driver is cyclical at the moment – that strengthening and broadening of growth around the world that is flowing through into earnings and revenues.”
Unlike in the past when much of this was seen in the US market solely, the manager said improving fundamentals are being seen around the world.
Yet, investors need to be cognisant that the ‘goldilocks’ market conditions of low interest rates and low inflation with higher growth cannot go on in perpetuity.
“I think we have to recognise that this can’t continue forever and that we probably suffer on both sides: the returns won’t be as good this year as last year and volatility should be higher,” he noted.
“We are not talking about significant moves here like a dramatic drop in returns or a big pick up in volatility.”
The big headwind for markets is inflation, with spare capacity eroded around the world leading to the expectation that at some point price rises are likely.
“The question is when and how quickly does it rise because it is that that determines when central banks have to start acting,” he said.
One area that the manager is unconcerned about though is valuations, which he described as “middle of the road” despite global markets rising strongly over the last decade.
Performance of index over 10yrs
Source: FE Analytics
“I wouldn’t go so far as to say that valuations are hugely extended. Clearly there are parts of the market that are more expensive than others but I wouldn’t say we are in bubble territory,” he said.
However, Chandler added that it would be hard to argue stocks are cheap and are certainly not as attractive as they were in previous years.
“Clearly the valuation argument we had five or six years ago isn’t there to the same extent across the broad market but there are still areas where we see value for example the emerging markets. I would not say we are at horribly overvalued levels,” he noted.
One area he said looks particularly attractive for the coming year is emerging markets, despite having a strong year in 2017.
“I think emerging markets, from a currency and market perspective, still scream to us as cheap,” Chandler said.
For many years the asset class was getting cheaper but the manager said the cyclicals were negative – meaning the team did not invest.
“We saw the fact that there was a lack of global demand, they had domestic financing vulnerabilities and those cyclical negative stopped us buying emerging markets,” he said.
This changed around 18 months ago when the team began to add exposure to emerging markets, he said, and continues to like the asset class from both a valuation and cyclical standpoint.
There are two major tailwinds that investors are concerned about when it comes to the emerging markets – a weak dollar and the prospect of interest rate rises from the Federal Reserve, but Chandler said the markets are now in a good place to withstand these.
Performance of index since start 2016
Source: FE Analytics
“I think that, from the dollar side, the weaker dollar is actually good for emerging markets,” the manager noted.
“It is helping them from a fundamental economic perspective in terms of the competitiveness they gain from being semi-pegged to the dollar.
“But also it enables those emerging market currencies that we still think of as being relatively cheap to appreciate and give you an additional return over and above what you get from domestic assets.”
Meanwhile, concerns over the ability to withstand Federal Reserve rate hikes, which was the main issue the team had when the asset class was cheapening four or five years ago, have subsided.
“We avoided emerging markets when they initially cheapened up because one of the things we saw was this domestic financing vulnerability and this dependence on external capital,” he said.
“We had very poor balance of payments, current account [and] government deficits but I think most have improved. They are not perfect but those vulnerabilities aren’t as bad as they once were and so they are better able to withstand rates.”
Conversely, he said the team have moved into emerging markets from an overweight position in Europe, where it had previously seen strong supporting factors from both a valuation and cyclical sides.
“We actually closed out the position because of euro strength and the way that impacts on exporters – particularly in Germany but also around Europe,” he said.