Emerging markets might look like the last place to invest this year as Britain’s exit from the European Union adds to global economic uncertainty and volatility. But a decent rally before Brexit in June suggests emerging markets are starting to turn.
The MSCI Emerging Markets Index (in Australian dollar terms) rose 8.06% over three months to May 31, 2016. The index, slightly lower in June, defied market fears that Brexit would crush investor appetite for risky emerging market assets.
Emerging markets have a reputation as a “hero” or “zero” investment: the best-performing asset class or the worst in a single year, such is the volatility of investing in equities in Asia (ex-Japan), Brazil, India or Russia.
These assets have a habit of delivering exceptional gains after long periods of weakness. Emerging markets underperformed developed market equities by about 60% over 1997 to 2001, then outperformed by more than 100% over the next six years.
Investors are drawing similar conclusions today: after badly underperforming developed markets over 2010-15, emerging markets are due for a period of strong growth. Some of the world’s largest fund managers, in their 2016 investment outlook commentaries published in January, noted the rising appeal of emerging market equities.
Their optimism was grounded in valuations. The average price-to-book ratio for the MSCI Emerging Markets index was 1.4 times at December 31, 2015 – well below its 10-year average of 1.9 times and half that of the US equities market at 2.8 times.
The price-to-book ratio for the closely watched MSCI Asia (ex-Japan) index was at an all-time low of 1.1 in January, on Nikko Asset Management numbers. In simple terms, Asian equities on average were worth only slightly more than their stated asset values.
Valuations hit rock bottom in late 2015 amid expectations that rising US interest rates would suck capital out of the region and back to the US, prompting a capital exodus similar to the 1997 Asian Financial Crisis.
The Bank for International Settlements warned that emerging market companies’ exposure to US dollar-denominated debt made them vulnerable to a rising greenback. These companies are thought to hold a third of US dollar-dominated non-bank debt.
Falling commodity prices weighed on sentiment towards emerging markets equities, despite low energy and minerals prices being a net benefit for the region in the medium term. India, in particular, is a winner for lower oil prices as its economy industrialises.
Some fund managers believed emerging markets were being valued as though another global financial crisis was imminent. Contrarians who know that the best time to buy emerging market equities is during real or perceived financial crises saw an opportunity to pounce.
Chart 1: Emerging markets rising this year off lows …
Source: Financial Times
Chart 2: … Gains coming after long-term underperformance against developed market equities
[1]
Source: Data by Bloomberg, chart by Aberdeen
Are emerging markets good value?
Let’s start with Brexit. The surprise vote to leave the European Union initially saw investors flock to safe-haven assets such as gold and US government bonds, because of an expected decline in global economic growth and an increase in government bond volatility.
Brexit’s impact on global growth is still unclear, as much will depend on Britain’s negotiations with the European Union (EU) and its other trading partners. It is too soon to know the risk of further political contagion in Britain (should Scotland push for succession again) and in Europe (if other nations follow Britain’s lead and leave the EU).
What is clear is the emerging markets’ low export exposure to Britain and the EU. China, for example, exports 2.6% of its goods to Britain and 13% to the EU, according to the Nikko Asset Management. India’s exports to the UK are broadly similar.
In fact, most Asian countries have low export exposure to Britain and the EU. Emerging markets in Europe (Czech Republic, Hungary, Poland, Turkey etc.) have much higher exposure, and need to be considered carefully in any emerging markets investment.
Brexit’s upside for emerging markets is the continuation of accommodative global monetary policy. Deteriorating global economic growth has raised expectations of extra monetary policy stimulus from central banks. Deferral of US interest rate hikes is likely; Fed fund futures are pricing less than a 50% chance of rate rises before 2018.
Stronger-than-expected jobs growth in the US last week boosted equity market sentiment as investors bet it would not lead to rate rises any time soon. Expectations of greater monetary policy from Japan and a possible resolution to Italy’s banking crisis also contributed to this week’s global rally in risk assets.
Equities markets in many developed countries are now trading at, or above, pre-Brexit levels. The relatively stable performance of emerging markets suggests investors believe the deferral of US interest rates outweighs any damage from Brexit to the region.
Signs of stabilisation in China this year and improving commodity prices, particularly iron ore, are other positives for emerging markets.
Clearly, the asset class has a challenging outlook, but some of the big threats (US rate rises, a sharper slowdown in China and falling commodity prices) have eased a little – yet aggregate valuations are still near multi-year lows.
Chart 3: Emerging market valuations in Asia near record lows
Source: Bloomberg
Will the returns rollercoaster continue?
I expect emerging markets to outperform developed markets in the next five years. However, gains will be smaller and nothing like the triple-digit outperformance after 2001.
Back then, emerging markets benefited from strong economic growth in China, rapidly rising commodity prices and improving global economic growth. None of those conditions exist to the same degree today.
Moreover, there is the risk of so-called “zombie” companies in the region, particularly in China, going bust in the next five years. Government support and record-low interest rates are propping up companies that should go bust, and tying up capital that should be reallocated to worthier business. The end of cheap money, when it arrives, will be messy.
Valuations are another consideration. Emerging markets have looked cheap for several years and kept getting cheaper. Fund managers who bought too early were burned. Relying on historic valuation norms is dangerous in such unusual markets.
Moreover, the aggregate price-to-book value – the metric emerging-markets observers place most weight in – could be artificially low if companies in the region have not sufficiently impaired (written down) assets. The 2008-09 Global Financial Crisis highlighted the dangers of relying on balance-sheet valuations when company assets or the value of non-performing loans in banks had not been sufficiently devalued.
Best emerging market investments
Investors should consider a small portfolio allocation to emerging markets that can be built during bouts of market weakness. The average allocation to emerging markets by international share funds – about 5% on Morningstar data – looks about right. Low exposure is warranted because of the risks. Conservative, income-seeking investors should avoid emerging markets.
Experienced, long-term growth investors should focus on emerging markets in Asia (ex-Japan) and including India, and avoid those in central Europe, Latin America, Russia and Africa.
Invest through a managed fund that specialises in emerging markets (preferably using the MSCI Asia ex-Japan as its benchmark index). Buying global equities directly in developed markets makes sense for some investors; but with emerging markets it pays to invest through a fund for diversification and to use the services of managers who specialise in this asset class.
I prefer actively managed funds over exchange traded funds (ETFs) that invest in emerging markets. ETFs have their place in portfolios, but copping the market return if emerging markets tank is a big risk. Investing through active managers who can get in and out of the region quickly, rather than accepting the index return, makes sense.
Listed investment companies (LICs) are a consideration. Asia-focused LICs, such as the Asian Masters Fund, PM Capital Asian Opportunities Fund, Ellerston Asian Investments, and Platinum Asia Investment, are trading at a discount to their net tangible assets.
The well-regarded Ellerston, for example, traded at a 14% discount to the value of its assets at June 16, ASX data shows. The PM Capital Asian LIC traded at 9%. In theory, investors could use these LICs to gain exposure to Asian equities (ex-Japan) at a discount, at a time when these markets are trading at multi-year-low valuations.
Among emerging market unit trusts, the Colonial Wholesale Global Emerging Markets Fund, the market’s largest by net assets, has starred. The three-year annualised return is 6.5% and over five years is 9.1%. The second largest fund, Aberdeen Emerging Opportunities Fund, has returned about 4% annually over three years.
The Vanguard Emerging Markets Shares Index Fund, Lazard Emerging Markets Equity Fund, Arrowstreet Emerging Markets Fund, and Mercer Emerging Markets Shares Fund are other top-10 funds in this category by net assets.
- Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness of the information, with regard to your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at July 13, 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.