After two years of strong returns following an interest rate hike by the Federal Reserve in December 2015, emerging markets have had a tough time so far this year.
But Ashmore Group's head of global research Jan Dehn says this is not down to emerging markets (EM) themselves.
The MSCI Emerging Markets index is down 3.31 per cent and JPM EMBI Global – which tracks emerging market bonds – has lost 5.28 per cent year-to-date (YTD).
Conversely the S&P 500 has increased 2.52 per cent and both the MSCI World and FTSE 100 have made positive returns.
Performance of global indices YTD
Source: FE Analytics
“I think this has very little to do with EM per se. I think it has mainly to do with a massive reversal in euro/dollar,” he said.
Indeed, the euro was up 13.8 per cent against the dollar in 2017, only for it to fall into negative territory in 2018 and year-to-date it is down 3.11 per cent against the dollar.
Dehn said this increase in the dollar has caused investors to sell off their emerging markets assets.
Although perhaps taking some profits in emerging markets was justified, he said, as the region had a strong year in 2017 – the MSCI Emerging Markets benchmark returned 30.55 per cent and JPM EMBI Global returned 9.32 per cent – investors that do so are running ahead of schedule.
“What we’re really observing here is more of a technical trade, a big profit-taking episode driven primarily by a move in euro-dollar,” said Dehn.
“And in many cases, the dog wags the tail when it comes to EM. People don’t really look at fundamentals, they just sort of trade it as a risky asset class. And when there’s a bit of risk-off, well then you sell emerging markets.”
Nonetheless, Dehn said this is not validated by the underlying fundamentals of emerging markets, which he believes are good, and he’s not the only one.
In its World Economic Outlook in April this year, the International Monetary Fund (IMF) forecasted that emerging market GDP will grow over the next couple of years before stabilising around 5 per cent in 2022.
Developed economies, on the other hand, are predicted to decline 0.8 percentage points by 2022.
Dehn said: “That means that the difference between the two – the EM growth premium – is going to rise steadily over the next five years. And that’s important, of course, because relative growth is a very important driver of investor flows.”
He went on to say that if the IMF, which is a conservative institution, is right in its forecast that emerging market growth will pick up over the next few years, then emerging market currencies will also pick up.
Since 2010, emerging market currencies, as shown in the below graph, have lost over 40 per cent and Ashmore’s Dehn believes they can recover 20 per cent of that loss.
“The reason why EM currencies can only recover half of what they lost on the way down is because EM inflation rates are running and will run significantly higher than developed markets,” he said.
Performance of EM currencies
Source: Ashmore, JP Morgan
Indeed, emerging markets inflation rates currently sit around 4.6 per cent while inflation in developed economies is 2 per cent, according to the IMF.
Dehn expects inflation in emerging markets to be between 4.5 and 5 per cent in the next five years and 2 and 2.5 per cent in developed countries.
This differential means emerging markets are around 2 per cent less competitive than developed markets per year and their currencies can only recover 20 per cent from a 40 per cent loss, he said.
He added: “But 20 per cent is still pretty attractive because if you’re going to get, say 20 per cent currency appreciation over five years, and at the same time you are being paid an average yield of around 6 per cent in bonds over that period of time, then you’re going to get 30 per cent from bonds (five years of 6 per cent), plus 20 per cent on the FX – that’s a 50 per cent return in dollars for 4.5 year government bonds that are 85 per cent investment grade.”
He went on to say that he doesn’t see any other bond market on the planet that has a five-year maturity and will pay you a 10 per cent return in dollars over five years.
“I don’t see it anywhere else frankly. This is a very cheap asset class,” Dehn said.
Looking at past performance, emerging markets bonds have performed better than American equities over the long-term (since 1999). The JPM EMBI Global index has returned 446.46 per cent compared to the S&P 500, which returned 187.10 per cent.
Performance of JPM EMBI Global index vs S&P 500 since 1999
Source: FE Analytics
Dehn noted that this outperformance has been achieved with less volatility and figures from FE Analytics show this to be true as JPM EMBI Global has had an average volatility of 8.93 per cent for this period compared to 14.40 per cent for the S&P 500.
What baffles Dehn then, is why no one is invested in emerging markets.
“Passive investors who could just have owned the JPM EMBI index should have had more money in emerging markets sovereign bonds than they had in the S&P 500 over the past 25 years,” he said.
“The fact of course is that nobody has. And it’s precisely because nobody has had more money there that the returns have been so big. Emerging markets is an underinvested in asset class.”