Korea, Brazil and Turkey are some of the most discounted emerging markets but not all are worth buying, according JO Hambro Capital Management’s James Syme.
Syme, who co-manages the JOHCM Global Emerging Markets Opportunities fund alongside Paul Wimborne said while these countries have the potential for a currency re-rating as well as an equity one, investors should consider whether they are a value trap.
He used the International Monetary Fund’s (IMF) annual External Sector Report, which not only identifies the major and riskiest imbalances as being the various large external surpluses and deficits in the developed world, but also undervalued emerging market currencies.
“The report is focused on the end of 2017, but it is possible to adjust those valuations by year-to-date moves to arrive at current estimates of currency valuation,” he said.
These can then be combined with equity market valuations to identify areas of the emerging market universe that are cheap overall.
First up is Turkey, which has seen a number of issues combine to undermine investor confidence more recently.
High interest rates of 17.75 per cent; rampant inflation approaching 20 per cent; a falling lira, down by more than 40 per cent so far this year; and, concerns over new trade tariffs from the US have all had an impact, with president Recep Tayyip Erdoğan coming under increasing pressure.
“After several years of being assessed as overvalued, the IMF 2018 External Sector report sees the lira as about fairly valued as at end-2017, which means it is substantially undervalued after the fall in the exchange rate year-to-date,” Syme said.
Performance of index over YTD
Source: FE Analytics
“We estimate the lira to be 9 per cent undervalued as at end-June 2018 and 14.2 per cent undervalued as at 6 August 2018.”
This had a significant impact on the country’s stock market, which is down 47.78 per cent so far this year in sterling terms, as the above chart shows. Turkish equities are currently priced at around 5.8x forward earnings (P/E).
“The IMF sees Turkey as needing to ‘adopt a credible policy package involving growth-friendly fiscal consolidation’ as well as reining in easy credit, and there is no doubt that the implementation of orthodox policies in Turkey would produce a very powerful rally in Turkish assets,” Syme added.
However, with no sign that policymakers are considering such steps, the manager said he remains negative on Turkey and would suggest investors look to invest elsewhere.
Another emerging market that looks attractive based on valuations is Brazil, where the IMF assessed the Brazilian real as being 2 per cent undervalued at the end of 2017.
Subsequent weakness suggests a current undervaluation of 3.5 per cent, while the equity market is cheap at 10.5x forward earnings, according to the JOHCM Global Emerging Markets Opportunities manager.
So far this year performance of the MSCI Brazil index has been choppy, currently down 7.38 per cent in sterling terms although this is higher than its year-to-date trough of 17.6 per cent.
Performance of index over YTD
Source: FE Analytics
Syme said: “The IMF’s view is that, in Brazil, ‘lower-than-desirable credit, amid weak investment, pushed up current account balances, masking underlying competitiveness problems that pushed the current account in the opposite direction.’
“This fits with our view and must be taken in the context of a fiscal problem that may, or may not, be addressed at the forthcoming October 2018 election – which we see as an absolutely key driver of Brazilian markets.”
Like Turkey, the country is another that has been rocked by a number of external factors as well as a corruption scandals that have dogged president Michel Temer and created some uncertainty over forthcoming elections.
As such, the manager said that he remains cautious on Brazil despite the potential for a re-rating in both currency and equities, although he is monitoring developments around the election to see if the political environment has improved.
The manager added: “We believe that both currencies and equity valuations are critical components of assessing the investment opportunity in emerging markets but, as can be seen in these two cases, one can ignore neither the political and policy environment, nor the credit and demand cycles, in emerging markets.”
Last up is Korea, which with its large external surplus, has a different profile to most emerging markets and in particular the previously-mentioned markets.
Unlike the others, Korea also has a supportive government which the manager said should be able to meet a number of key objectives.
“Overall, the IMF report sees Korea as having a higher-than-desired current account surplus, with the remedies involving a stronger currency and looser fiscal policy,” he said.
The Korean won was undervalued to the tune of 4.5 per cent at end 2017 and this has widened to 4.7 per cent currently.
Meanwhile, Korean equities are priced at just 7.7x forward earnings with the MSCI Korea index falling by 7.8 per cent in sterling terms so far this year.
Performance of index over YTD
Source: FE Analytics
Syme said: “We believe that the policies of the more left-wing Moon administration will achieve both of these aims, resulting in stronger domestic demand growth and an upward lift to returns from a stronger currency. Korea is one of our favourite markets.”
Syme and Wimborne manage the £309m JOHCM Global Emerging Markets Opportunities fund using a top-down approach while looking for quality-growth names within their preferred markets.
The biggest overweights in the fund include Korea and India while China is the largest relative underweight.
Over the past five years the fund has been a top-quartile performer in the IA Global Emerging Markets sector, up 71.87 per cent. It has a clean ongoing charges figure (OCF) of 1.07 per cent.