Emerging markets have moved to “rare” valuations after being oversold on fears over the impact of Turkey and Argentina, according to Rathbones’ Ed Smith. 
Smith (pictured), head of asset allocation research and a member of Rathbones’ strategic asset allocation committee, said the firm had added to its positions in US and emerging market equities for quite different reasons.
Emerging markets have failed to emulate the double-digit returns recorded last year, sinking to high single-digit losses in 2018 so far as ongoing challenges for a number of countries hit investor sentiment.
However, Smith said emerging market equities have reached a “rare” valuation opportunity when compared with other markets.
“If you look at some of the technical indicators, emerging market equities – relative to US or global equities – have got to three standard deviations oversold on a Bollinger Band-style analysis and that’s quite rare,” he said.
As the chart below shows, the MSCI Emerging Markets index moved close to three standard deviations – a measure of volatility – lower than the 21-day exponential moving average (EMA) during the summer, suggesting the market could be oversold.
Bollinger Band analysis of index (21-day EMA, over 1yr)
Source: FE Analytics
Smith, who noted that Rathbones has also been adding to its emerging market debt exposure, said: “We were quite keen to take advantage of that relative valuation opportunity because we think markets have really over-extrapolated from Turkey and Argentina.
“Most emerging markets are in – at least in terms of their solvency – pretty good health and current account balance sheets are much improved from where they were five years ago, when the ‘taper tantrum’ roiled emerging markets.”
Indeed, Smith said when considering the ‘immediate foreign funding requirement’ indicator for emerging economies, just a handful were at risk of failing.
The indicator tracks current account balance, short-term foreign-held debt maturing in the next 12 months, and official reserves of each country.
As such, Smith said just four of 20 emerging market economies had any need for foreign funding or relying on the “kindness of strangers” for day-to-day solvency.
The Rathbones head of asset allocation research said those four included Turkey and Argentina, as well as Pakistan and South Africa.
“They’re not likely to bring the whole global economy crashing down, so all of the big emerging markets don’t rely on the kindness of strangers and are far less susceptible,” he said.
The other themes that have been weighing heavily on emerging markets are the rising US dollar and the potential impact of trade wars.
“We think the dollar won’t appreciate too much further from here,” he said. “We don’t necessarily think it’s going to depreciate from here, but we can’t see it appreciating too much more.”
Smith said the dollar looks overvalued based on a number of metrics and has several challenges to overcome.
“America has got to fund a ballooning deficit and that tends to weigh on the dollar or has done historically,” he explained. “More short term the technicals have got very stretched on the dollar; it looks like every man and his dog has gone long-dollar recently.
Performance of US dollar vs selected EM currencies over 1yr
Source: FE Analytics
Given the challenges facing the dollar, Smith said a strong greenback was less of a reason to avoid emerging markets than it has been previously.
However, he caveated that by saying the firm would advocate selecting countries that are less sensitive to a rising dollar, such as Mexico, Malaysia, Indonesia or China.
The other headwind facing the asset class is the potential for an escalating trade war involving US and China, but which has also has knock-on effects for other markets.
“Even though it seems to be just between the US and China there are of course lots of other countries in our globalised world feeding into that supply chain to China and the US,” he explained. “Lots of other countries make the component parts that China then assembles and ships to the US.”
Nevertheless, Smith said emerging markets appear to be offering good value for investors willing to look past some of the current challenges.
“We’ve already seen quite a slowdown in global trade this year, but does it justify the extraordinary divergence in the valuations and performance of US assets to emerging market assets? We don’t think it does,” he added.
As well as adding to its emerging market exposure, Smith said Rathbones has been balancing that trade by adding to US equities after learning a painful lesson last year.
“We did very well out of US equities for many years but went slightly underweight last year,” Smith explained. “We hold up our hands, that was the wrong decision.
“We still have a large amount of client assets in the US but we went underweight and it meant we missed out on some strong performance. We’re still not back to overweight but we’ve gone back to neutral.”
Smith said exposure to US equities acted as a complement to its increased weighting towards emerging markets by taking “a bit of cyclicality out the portfolio”.
“Globally the economy is probably not going to do any better than it did last year and in fact might slow slightly and in that environment you want slightly more defensive sectors in your portfolio,” he explained.
“The US is actually one of the least cyclical markets out there. It has one of the lowest sensitivities to global industrials, for example.”
However, Smith said even the US market’s cyclical stocks are performing better than elsewhere thanks to the strength of the economy.
However, he warned that active stockpicking is crucial in the current environment – despite the ongoing bull run – as it has “some problems underneath the surface of the US equity market”.
One issue is leverage and interest cover within the S&P 500, which might seem lower overall but from a median level is higher than it has been for 15 years.
“There is a bit of a balance sheet problem and we want active stockpicking to make sure we avoid weaker balance sheets, particularly as we’re nearing the end of the cycle and interest rates are going up,” he said. “We want to protect ourselves from interest rates going up to quickly.”
Performance of S&P 500 sectors over 1yr
Source: FE Analytics
Smith also noted that there was a bit of a divergence between returns within the S&P 500 index, despite a strong return for the broad index overall in 2018.
“It’s not just the FAANG [Facebook, Amazon.com, Apple, Netflix and Google-parent Alphabet] stocks doing well, there are plenty of other names that have done well,” said Smith.
“But there is also an extraordinarily large number of names that have lagged behind this year. In fact, somewhere between 200 and 250 names – between 40 and 50 per cent of the index – is still 10 per cent below their high watermark, in terms of stock prices. That’s very unusual this far away from a large fall in the broader market.”