Interactive Investor

Emerging markets have returned to form - time to buy?

18th May 2017 08:42

Marina Gerner from interactive investor

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After five difficult years, emerging markets have returned to form over the past 12 months. Over the past five years there were some $80 billion (£63 billion) of outflows from emerging market equities, and the average global investor went underweight in the sector, says Bernard Moody, co-chief investment officer at Aberdeen. Last year this trend reversed, and the asset class saw some $7-8 billion of inflows as currencies stabilised.

Political factors have been influential in emerging market countries: the continuing fiscal and economic reforms of India's prime minister, Narendra Modi, who is widely seen as pro-business, for example. Favourable developments have included China's ostensible avoidance of a 'hard' economic landing and the impeachment in 2016 of Dilma Rousseff, then president of Brazil, which sent the Brazilian market soaring. Commodity prices have also rebounded.

Compared with 12 months ago, emerging markets look a lot more attractive, says David Stubbs, global market strategist at JPMorgan. In 2015 commodity prices and emerging market currencies were falling, but the sector started to turn a corner in early 2016. Reassuringly, he points out that two-thirds of the MCSI Emerging Markets index now consists of consumer, finance and technology businesses, which are all promising sectors for future development.

Stubbs says: "Given the growth story, investors should consider emerging markets for the long term. The upside for emerging market currencies is now much higher than the downside." The current accounts of the 'fragile five' (Turkey, Brazil, India, South Africa and Indonesia) - so named because of their large current account deficits, which mean they rely on external investments flowing across their borders - have improved.

Omar Negyal, co-manager of JPMorgan Global Emerging Markets Income Trust, says: "The recovery currently underway in a number of emerging economies and the stability we foresee in China this year support expectations of a broad-based turnaround in emerging market fundamentals in the medium term."

His sentiment is echoed by Carlos Hardenberg, lead portfolio manager at Templeton Emerging Markets investment trust, who says: "After more than three years of languishing at depressed levels, the earnings of emerging market firms are showing signs of recovery, and that is reflected in the attitudes of companies and their managements as well as firms' financial data."

Recounting a recent trip to Dubai where his team met a range of companies from Africa, the Middle East and other emerging markets, Hardenberg says: "[They] were far more confident and open in sharing their outlook for the next 12 to 24 months."

He argues that after a relatively bleak period for emerging markets, it seems many factors that have historically attracted investors to these markets - including stronger earnings growth than developed markets, higher GDP growth and more attractive consumer trends - may be coming back into play.

Evolving story

Emerging markets are evolving and not just emerging, according to Hardenberg. The kinds of emerging market companies he currently invest in are a world away from the firms his team analysed a decade or two ago. Technology and digital businesses have established themselves much more firmly in the region.

He says: "The emerging market corporate landscape in general has undergone a significant transformation from the often plain vanilla business models of the past, which tended to focus on infrastructure, telecommunications, classic banking models and commodity-related businesses, into a new generation of highly innovative companies that are moving into technology and much higher value-added production processes." He adds that some very strong global brands have originated in emerging market countries.

Back in the late 1990s technology-oriented companies made up just around 3% of the corporate universe represented by the MCSI Emerging Markets index. Hardenberg says: "Even six years ago, information technology firms represented less than 10% of investable companies in the index."

Much has changed since then. Today around a quarter of companies in the MSCI Emerging Markets index are IT companies, including hardware, software and component suppliers.

While much of this activity is originating in Asia - including Taiwan, South Korea and increasingly China - similar development can be seen in Latin America, Central and Eastern Europe and even Africa.

Hardenberg says the IT sector can be difficult to understand and value. Business models are rapidly changing as they adapt to the shifting demands of consumers and respond to new environmental regulations. Currently, he has identified opportunities among some larger companies, but he generally tends to favour medium-sized companies with potential to outgrow the market as a whole.

Companies in emerging markets have evolved rapidly, but Hardenberg is adamant that the emerging markets asset class remains one in which active management continues to play an important role. He says: "Emerging markets tend to have their own business rules and regulations which affect companies. Firms differ greatly in their attitude towards minority investors, governance standards vary significantly, and local intricacies determine consumer trends and habits. We often need to develop fairly close relationships to gain a better understanding of business prospects and find successful management teams that respect the rules."

Risk worth taking

Global emerging market equities remain subject to external risk, says Moody. US president Donald Trump has talked about taking jobs back to the US - although markets have shaken that off, given that his election campaign promises are proving difficult to deliver.

Traditionally, a strong dollar has also been bad for emerging markets, says Stubbs, "but it is now less of a red flag". He adds that the dollar is strong, but emerging market equities have done fine anyway.

Negyal is more cautious. He believes that "dollar strength and the direction of US trade and foreign policy under Trump's administration remain the most important risks".

Trump's policies pose more of a risk to some emerging market countries than others. Stubbs says exports to the US represent a low proportion of Brazilian and Indian GDP, for example, but Mexico is vulnerable if Trump's proposed border controls come into play.

US rate rises are another potential hazard. However, Moody believes they are likely to arrive slowly and remain modest, and they will only happen at all against a backdrop of a robust US economy.

Moody adds: "Of course, there will always be political risks. North Korea is sending missiles in the direction of Japan; China's party plenum is coming up later this year." But there are always risks, and those who invest in emerging market equities are paid a premium for taking those risks.

Could Brexit derail emerging markets? It's unlikely, according to Moody. The eurozone and the UK are important parts of the global economy, but their significance to emerging markets is not huge. "Are we going to buy fewer electronic gadgets from Korea and Taiwan because of Brexit? Probably not."

Spotlight: JPM global Emerging Markets Income

This trust, managed by Omer Negyal, is underweight in Korea and China, and overweight in Taiwan and South Africa. It returned 6.1% over the three months to 10 April, compared with a sector average of 6%. Over one year it returned 43.8%, compared with a sector average of 32%. Over three years it returned 26.6%, compared with a sector average of 24.4%.

The MSCI Emerging Markets index is heavily dominated by China, which makes up 27% of the index. But many active managers are underweight in China compared with the index.Negyal is one.

He says: "We typically don't like investing in companies with state involvement, so we have no exposure to the large banks, for example. The other large part of the market to which we have no exposure consists of internet names such as Tencent, Alibaba and Baidu. These are good companies, but they pay little or no dividend (Tencent yields just 0.2%)."

His fund is also underweight in South Korea, because of domestic companies' governance issues. He says: "Korean businesses are typically family run and complicated, which often means shareholders and dividends are not on their priority lists. Korea is renowned for having one of the lowest payout ratios of any market globally." As always, the fund's country and sector positions are the result of individual stock decisions.

He adds that his fund's long-term approach led him to invest into weakness in Brazil, Russia and South Africa in 2015, "and has also led us to increase our Mexican exposure during 2016. The Mexican peso weakened throughout the year, allowing us to build positions in quality companies (Walmart de Mexico and Fibra Uno) we believe offer strong income and growth potential."

However, following the sharp decline of the market and currency after the US election result, the headwinds faced by quality businesses hurt the fund's performance.

He says: "Another laggard market, Turkey, has also provided attractively valued opportunities, so we have increased our overweight there a little, with oil refiner Tupras a recent addition."

From a sector perspective, he favours telecoms and consumer companies, while he is less keen on industrials and energy.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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