Investors should expect a bounce back by emerging markets in the medium term despite recent underperformance, according to Legal & General Investment Management’s Justin Onuekwusi.
Onuekwusi, who is head of retail multi-asset funds, said the region continues to be “fundamentally attractive” and will benefit those who are willing to be patient and look through short-term noise.
Compared with last year, emerging market assets have underperformed as the rampant US dollar has started to take a toll.
Indeed, 2017 saw stellar performance by the world’s developing economies – led by strong returns by both China and India – as the MSCI Emerging Markets index recorded gains of 25.40 per cent.
However, 2018 has seen investors dumping the riskier emerging markets for the safety of US assets.
While the S&P 500 has delivered a 13.06 per cent total return year-to-date, the MSCI Emerging markets index is down by 4.23 per cent.
Performance of indices YTD
Source: FE Analytics
The US economy continues to benefit from strong growth and fiscal stimulus in the shape of US president Donald Trump’s tax cuts. Furthermore, interest rates hikes have helped to propel the dollar upwards, making life increasingly difficult for emerging market economies.
However, Onuekwusi said if investors are willing to be patient and look through short-term noise, they will be able to take advantage of the medium-term trends in the markets.
“We are positive on emerging markets hard-currency debt [US dollar-denominated debt],” Onuekwusi said.
“It has been very painful this year to be honest, but if you are willing to be patient, the cheapest asset classes will eventually start to rise in value relative to everything else.
“Sometimes it takes a long time, but you have to look through the noise.”
With yields currently well-above 5 per cent, the manager is currently finding value in emerging market debt and noted those developing economies remain in good shape despite falling market sentiment.
“I would say default rate isn’t that large,” said Onuekwusi. “Okay, you have had idiosyncratic risks in Argentina or Turkey. This is a widespread emerging markets’ stress, but they are unlikely to default in hard-currency debt.
“Since the Asian crisis you have seen emerging markets build up a lot of foreign reserves, a lot of euros, dollar, sterling… Which means they are unlikely to default.
“Even China, the country doesn’t have a lot of overseas debt, but they have $3trn of US dollar reserves.”
The foundation of a multi-asset portfolio lies in diversification across all asset classes, which may hamper returns over the short term given the current US growth-dominated investment backdrop, the LGIM manager noted, but it can pay-off in the long term.
“We believe that, over time, diversification is the best way to create an efficient portfolio. For example, you won’t see a huge UK bias in our funds,” he said.
“In that environment of US growth, diversification doesn’t work. We have tilted the portfolio slightly to the US but – relative to other peers who have started with 100 per cent allocation to the US – of course the returns aren’t that extreme.
“As we are coming to late-cycle and we are moving to an environment where the market is starting to think when the next recession is going to be, volatility is going to pick up. So, diversification is going to be more and more important,” Onuekwusi explained.
He said currently the team is keeping an eye on three key risks, including: major economies’ central banks (particularly the Federal Reserve), China, and the rise of populism.
US interest rates over 10yrs
Source: FE Analytics
However, when asked about risk, Onuekwusi said they are neither risk-on nor risk-off, as the risks aren’t extreme, there is still some value in the market and overall global growth remains strong.
“We are monitoring central banks and in particular the Fed,” he said. “If they get behind the curve in terms of inflation and they have to start rising rates aggressively, that means yields will go up in bonds, bonds will fall, and equities are likely to fall as well. Putting up rates squeezes liquidity.”
Given that scenario, the team is doing two things. Firstly, they are tilting lower-risk portfolios towards the US dollar, which will provide protection if the Fed increases rates. Secondly, they are biasing their portfolios towards index-linked bonds.
“50 per cent of our government bond exposure is now in inflation-linked bonds,” he explained. “Why? Because, why would the Fed get behind the curve? Why would it really have to increase rates quickly? Because inflation is taking control.”
The second risk is China, a country Onuekwusi noted will see its growth slow down over the next five years.
The last and final risk on the LGIM manager’s radar is the new political paradigm seen in countries like the UK or the US.
“We are seeing voters reject established political institutions. With Brexit, for example, when the electorate chose against the establishment,” said the multi-asset manager.
“That rise of populism is likely to continue and, what does it mean for asset classes? You have to take each political event on a case-by-case basis but, with the US and China for example, if it [the trade war] remains contained between both countries, it shouldn’t have a massive impact on markets.
“However, if it starts to spiral, then it will start having a real impact on markets.”
The £924.4m L&G Multi-Index 5 fund is part of a range of risk-profiled funds (where the risk profile ranges from 1-10 with 1 being the least risky, and 10 being the most).
The fund range aims to provide a combination of growth and income while remaining within a pre-determined risk profile. The level of risk is managed by restricting the types and proportion of assets it holds.
Since launch, the five FE Crown-rated fund is up by 46.92 per cent comparted with a gain of 39.98 per cent for the average IA Volatility Managed sector fund.
Performance of fund vs sector since launch
Source: FE Analytics
L&G Multi-Index 5 has an OCF of 0.31 per cent.