The rebound in resource stocks and commodity prices is an early choice for this year’s Factor X: the surprise trend that financial markets and commentators missed. Another related contender is the rally in emerging markets, which traded at multi-year lows in January.
I missed the strength of the resource-sector and commodity-price rally and am still not convinced about its sustainability. The global economy’s fragility remains a challenge for metal prices and a bigger cutback in commodity supply is still needed.
I was more bullish on emerging markets, principally because of their aggregate valuation.
In July, I wrote for the Super Switzer Report that emerging markets were poised to outperform over the next five years: “Clearly, the (emerging markets) asset class has a challenging outlook, but some of the big threats – United States rate rises, a sharper slowdown in China, and falling commodity prices – have eased a little, yet aggregate valuations are still near multi-year lows.”
The MSCI Emerging Markets Index rallied 9% (in US dollar terms) over three months to September 2016 and is up about 16% on a year-to-date basis. In Australian-dollar terms, the index was up almost 10% in the calendar year to September 30. So far, so good.
Some big headwinds for emerging markets are easing. The first is improving commodity prices, which tend to move in the same direction as emerging-market equities – a correlation I’ve never quite understood. Most countries in the MSCI Emerging Markets Index benefit from lower commodity prices: think India and coal/energy imports. But demand for “risk assets” tends to drive commodity prices and emerging markets higher.
The second trend is market expectations for US interest-rate rises and a stronger Greenback. Emerging-market equities were crunched last year amid fears that US interest-rate rises would spark a capital exodus from emerging markets to the US, in search of higher yield.
The doves’ argument of continued low US inflation, below-trend economic growth and gradual rate rises from here is still the consensus view.
I outlined the case for modest US rate rises in the Switzer Super Report earlier this month. It’s hard to see a faster-than-expected lift in US interest rates causing a capital flight from emerging markets, and developing Asian economies generally have stronger sovereign balance sheets and greater capacity to withstand higher debt costs, should global rates rise.
The third main factor is China. A slowing Chinese economy, surprise devaluation of the Yuan and a slump in the country’s equities last year were an awful backdrop for emerging markets.
China’s economy grew steadily at 6.7% in the three months to September and there seems to be more clarity on its currency and the underlying strength of its economy. Nevertheless, some commentators have suggested China’s growth looks “uncannily stable”. China remains a key risk.
Gaining exposure to emerging markets
Extra care is needed when investing in emerging markets. Most portfolios should only have a fraction of their assets invested in this asset type. The average emerging-market allocation in international share funds, managed from Australia, is about 5%, according to Morningstar.
Conservative investors who cannot withstand short-term volatility or who need reliable income from their investments should avoid these assets.
Moreover, investors in emerging markets ideally should take a seven- to 10-year view. Annual returns from emerging markets can have large swings – a reason why the asset class is sometimes referred to as a “zero or hero” performer. The best strategy is adopting a long-term approach to smooth return volatility and position portfolios for the coming boom in middle-class consumption in emerging markets.
I favour using active fund managers over index managers for emerging-market exposure. Exchange Traded Funds (ETFs) have their place in portfolios but the extreme volatility of emerging markets at times warrants the use of professional managers who know the region, run diversified portfolios and can quickly increase cash weightings in downturns.
Most of all, investors need to understand the heightened risks in emerging markets before latching on to the recent price uptrend. This is no place for faint-hearted, inexperienced or conservative income-seeking investors. Emerging markets, by their nature, are more volatile than developed markets and can deliver persistently low or high returns over long cycles.
Can outperformance in emerging markets continue?
Caveats aside, the recent outperformance of emerging markets has further to run. Emerging-market equities massively underperformed those of developed markets between 2010 and 2015 and aggregate valuations remain low by historical standards.
Do not expect a repeat of similar cycles when emerging markets underperformed developed markets by about 60% from 1997 to 2001, then outperformed by 100% during the next six years. Gains will be smaller and risks higher.
The drivers of emerging-market outperformance are not as strong this time. We don’t have the emergence of China as an economic powerhouse and a once-in-a-generation bull market in commodities putting a rocket under emerging-market equities, as was the case at the start of the previous decade.
Further, the global economy is expected to expand by only 2.9% this year and 3.2 % in 2017, according to the OCED’s latest Interim Economic Report – hardly the growth backdrop for a sharp, sustained rise in emerging-economy countries.
But valuations, although not as attractive after recent gains, still support emerging-market investments.
The MSCI Emerging Markets Index traded at a price-to-book ratio of 1.4 times in March 2016 – a level observed only four times during the past 20 years (1997 Asian Financial Crisis, Latin American Crisis, Gulf War and Global Financial Crisis). A period of strong outperformance in emerging markets over developed markets followed each time the ratio hit that level.
The MSCI Emerging Markets Index’s price-to-book value ratio, which compares a company’s share price with the historic book value of its net assets, was 1.54 times at September 30, 2016, MSCI data shows. By comparison, the price-to-book value ratio on the US S&P 500 index was 2.84 times in October. On that basis, emerging markets look reasonably valued.
Choosing exposure
In unit trusts, the Colonial First State FirstChoice Wholesale Emerging Markets Fund, the market’s largest by net assets, stands out. The three-year annualised return is 7.11% and over five years it is 8.4% to September 30, 2015.
The next-largest fund, Aberdeen Emerging Opportunities, has returned about 9% annually over five years to September 2016 and is well managed and rated.
The Vanguard Emerging Markets Shares Index Fund, Stewart Investors Wholesale Global Emerging Markets Sustainability Fund, Lazard Emerging Markets Equity Fund, Arrowstreet Emerging Markets Fund, and Mercer Emerging Markets Shares Fund are other top funds in this category, by net assets, and worth considering.
Listed investment companies are an improving source of emerging-market exposure. Several prominent international equity managers have listed LICs that invest in Asian equities (excluding Japan) in the past two years through initial public offerings (IPOs) on ASX.
They include Platinum Asia Investments, Ellerston Asian Investments and the PM Capital Asian Opportunities Fund. The Asian Masters Fund and the Emerging Markets Masters Fund are other options for exposure. Most of these LICs are trading at a discount to the market value of shares held in their fund.
The iShares MSCI Emerging Markets ETF, SPDR S&P Emerging Markets Fund, and Vanguard FTSE Emerging Markets Shares ETF are the main choices for index exposure to emerging markets. Vanguard has the lowest annual management fee.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 19 October 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
