Is it time to embrace or escape from Emerging Markets?

One of many aphorisms uttered by investment legend Warren Buffett is that: “You cannot buy what is popular and do well.” The implication is therefore that the best portfolio returns are generated when advisers and clients take exposure to an asset class, geographic region or investment theme when no-one else is looking and valuations are therefore appealing – in that they provide downside protection and also upside potential.

A classic example of this in the field of global equities is Emerging Markets. They were almost friendless during 2012 to 2015, as commodity prices sank, the dollar rose and interest rates were taken higher to combat inflation, even as economic growth generally disappointed.

But as proves to be so often the case, the darkest hour was before the dawn as valuations and expectations fell so low that it took little to provide an upside surprise.

Emerging Markets began to gain momentum in 2016 and they outperformed handsomely in 2017.

Emerging Markets have led the way since 2015 after a long period in the doldrums

Source: Thomson Reuters Datastream

Yet cracks have begun to appear in 2018. Fresh US sanctions have taken a toll on Russia. Mexico and Brazil are nervously awaiting elections (as is Turkey, even if the result here is in no doubt). Currencies such as the Mexican peso, Turkish lira, Russian rouble and Indonesian rupiah have lost ground on the dollar. Some economies in Asia have begun to overheat. And the Federal Reserve has continued to tighten monetary policy, driving the yield on the US 10-year Treasury yield to 3%, a level which just might tempt cash to quit more exotic fields in search of more dependable returns nearer to home.

Certain Emerging Market currencies have started to wobble, including the Turkish lira, Russian rouble ...

Source: Thomson Reuters Datastream

... the Mexican peso and the South African rand

Source: Thomson Reuters Datastream

So the question to address now is should advisers and clients continue to embrace or start to escape from emerging equity markets?

Broad universe

Advisers and clients need to remember that not all emerging markets are alike, even if they tend to get bracketed together.

  • Some are commodity exporters who benefit from higher prices (Brazil, Russia, South Africa), others are net importers who prefer lower prices (India, Korea, China).
  • Some are politically stable (for democratic or other less satisfactory reasons), some are embracing much-needed reform (Argentina, South Africa), others are on a knife-edge as we approach elections (Mexico) and others are subject to tight central control (Turkey, China) which may or may not end up being a good thing for the economy.
  • Some markets are looking very pricey relative to their own history or their Emerging Market peers on a range of metrics (India and perhaps South Africa, for example) while others may be cheap (Russia, South Korea, using price-to-book value, relative to return on equity, at least), according to research compiled by M&G’s Emerging Markets team.

Given these factors it should be no surprise that the 23 nations which comprise the MSCI Emerging Markets stock index have provided a wide range of performance in 2018 – and that is in local currency terms, or before any movement in their currencies against the pound are taken into account.

Emerging markets have offered a wide range of returns already in 2018

Source: Thomson Reuters Datastream. *(Local currency, capital return only).

Two rules of thumb

A well-chosen fund manager should be on top of all of these issues and more as they sift for good value and under-appreciated narratives by stock, industry or country. Some will prefer the momentum offered by hot sectors like technology, rising oil prices for energy stocks or falling interest rates for banks. Others will have a more value-oriented approach and be prepared to take on political risk, in the view that any upset could be short-lived, especially for well-run firms.

But for time-pressed advisers and clients who are swamped with information and have asset allocation decisions to make, there are two simple rules of thumb with regard to Emerging Markets which seem to stand the test of time, at least on a near-term tactical basis.

  • A strong dollar tends to be bad news, a weak one good news for Emerging Markets. This harks back to the 1997-98 Asian and Russian debt crises: a rising dollar makes it more expensive to service overseas debts and also makes commodities more expensive to buy for nations whose currency is not pegged to the dollar. The greenback has been weak for over a year but Federal Reserve determination to raise rates and sterilise Quantitative Easing (QE) could now be boosting the buck. Turkey, with galloping inflation, a current account deficit, budget deficit and substantial overseas borrowings is a potential fault-line here.

Historically a weak dollar has been good for emerging equity markets, as 2017 showed

Source: Thomson Reuters Datastream

  • Strong commodity prices tend to be good news and weak ones bad news for Emerging Markets. Further evidence of a strong, synchronised global recovery should therefore be a potential positive for Emerging Markets. Any sign of a slowdown, loss of faith in an inflationary upturn or re-emergence of fears over deflation would be a potential negative for emerging markets, even if, as we all know, the past is by no means a guarantee for the future.

Historically strong commodity prices have been good for emerging equity markets

Source: Thomson Reuters Datastream

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.