Are The Stars Aligning For Emerging Market Investments?

A legacy of years of ultra-low interest rates, high government debt, and subdued economic growth in developed markets around the world is that investment returns from all major asset classes are low and likely to remain low for some time.

As investors consider how to diversify away from these subdued fixed income and equity markets in search of better returns, many are finding that emerging markets (EM) offer both attractive value and better long-term growth prospects.

EM assets have not shared the recovery that developed markets experienced since the financial crisis of 2008/9. Instead many of these EM assets came under considerable pressure during the 2011/15 period due to a combination of weak economic fundamentals, geopolitical risks and the stronger US dollar.

We now believe conditions have changed for the better based on a risk/reward assessment that takes into account fundamental factors, valuations and risks. These factors combined means we think the case for investment in EM assets is now stronger than it has been in recent years.

Our assessment of various investment factors fundamentals including recent data, show an increase in economic activity and an improvement in both the current account balances and external debt profiles of a number of developing economies. In addition, inflation in many of these countries is trending lower.

From a valuation perspective, the current pricing of EM assets does not reflect any of these developments, or indeed, data showing that GDP growth in EM economies is once again outpacing that of developed economies.

An important point for investors to consider is that historically, when growth in EM outpaces that of developed markets, it is a reliable indicator in our view that EM asset outperformance will follow.

After more than five years of underperformance, EM asset prices, including equities, fixed income and currencies are showing signs of deep undervaluation. While this is starting to reverse, there remains a lot of room for EM valuations to catch up with developed markets, so this trend could continue.

EM asset valuations have experienced numerous shocks in recent years, including the Fed’s taper tantrum, fears around China meltdown and idiosyncratic risks such as Russia’s military intervention in the Ukraine and Brazil’s corruption scandal. These have all taken place in a backdrop of falling commodity prices and a stronger dollar.

We believe many of these risks have now subsided. Yet, valuations continue to reflect a level of risk reminiscent of the 1997-1998 Asian financial crisis.

Of the remaining concerns that could affect EM growth in the medium term, the prospect of higher interest rates in the US and potential systemic risks surrounding the state of China’s economic future continue to hold the attention of investors. In the US, the Federal Reserve has adopted a cautious stance despite strength of domestic data as the focus has turned towards weak international developments. But in China historic structural changes are still underway, so economic news from there requires close attention.

Investors’ concerns regarding China, which started in April 2015 with the sharp devaluation of CNY, generally revolved around fears of a slowdown of the economy and the very high level of debt. We believe China’s position as a net creditor to the world and the very liquid asset profile of its external balance sheet, provides a key backstop against the risk of a full financial meltdown. In addition, China still has around 3.2 trillion of reserve providing a large cushion in case of significant deleveraging of the economy.

EMs now offer a very attractive opportunity, especially in light of the low-yield environment in developed economies. However, those considering EMs should reflect on the different situations in fixed income and equities.

In fixed income, a new paradigm where central banks are dominant players and regulation has tightened means that today’s world is characterised by fractured liquidity and increased commonality in investors’ portfolio. In this context, moving away from traditional benchmarks which reward the most indebted countries and instead focussing on the issuers with the best underlying fundamentals in our opinion could prove a better option. An approach focusing on the quality of the issuers and requiring trading less frequently will lead to a portfolio which is less exposed to growing liquidity and market risks.

For EM equities, the situation is different and liquidity is much better. On this basis, investors should consider a high-conviction approach, which is where a fund manager uses skill to research each company within the EM equity universe and to know the factors that influence these companies return.

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