My suggestion in December 2015 to add more emerging-market exposure to portfolios was among the hardest this column has made in the past few years. Emerging-market equities were horribly out of favour at the time and even hardened contrarians avoided them.
Falling commodity prices, fears of a sharper slowdown in China and talk of a capital exodus from the East to the West as the United States raised interest rates was toxic for emerging markets. The MSCI Emerging Markets Index fell almost 17 per cent in 12 months to October 2015.
I wrote for The Bull in December that year: “History shows the best time to buy emerging markets is often during real or perceived crises when panic selling creates opportunities … The case to lift emerging-market allocations cautiously within portfolios is strengthening.
I added: “Nobody says it is easy buying assets when there is so much negativity in commentary and when uncertainty is rife. But the worst-performing assets over a decade have habit of outperforming the following decade. That will be true of emerging markets in time.”
The column outlined the usual risks of investing in emerging markets and the many headwinds facing the asset class in 2016. It was reckless not to: emerging markets, a riskier asset class, should only ever have a small allocation in portfolios – less than 5 per cent for most.
But emerging-market valuations looked historically cheap on several measures. The average price-to-book ratio for the MSCI Emerging Markets Index was 1.4 times at December 2015 – well below its 10-year average of 1.9 times and half that of US equities at 2.8 times.
The price-to-book ratio for the closely watched MSCI Asia (ex-Japan) Index hit an all-time low of 1.1 in January 2015, on Nikko Asset Management numbers. Simply put, Asian equities on average were worth only slightly more than their stated asset values.
Markets, it seemed, were valuing emerging-market equities as though a crisis was imminent. They had underperformed those in developed markets for five years.
Fast forward 10 months to October 2016 and emerging markets are returning to favour. Emerging-market equities outperformed developed-market equities in the third quarter of 2016 and momentum in the asset class is building, says investment firm VanEck.
David Semple, portfolio manager for VanEck’s Emerging Markets Equity strategy, this week said: “Emerging-market equities have generally underperformed over the past 4-5 years, but the tide is turning. Emerging-market growth relative to that of developed markets is at its highest since 2014 and we believe these markets will continue to outperform developed markets over the next five years.’
The MSCI Emerging Markets Index (in US dollar terms) is up 14 per cent year-to-date. The iShares Emerging Markets ETF, identified in my December 2015 The Bull column, was up 10.5 per cent this calendar year to August 31 (in Australian-dollar terms).
Several factors are driving gains: firming commodity prices (emerging markets such as Indonesia are minerals exporters), signs that China’s economic slowdown is stabilising and market expectations for gradual US interest-rate rises.
ll these factors worked against emerging markets at the end of 2015. Now they are working for emerging-market equities, although many risks remain. VanEck’s Semple said: “… We don’t expect to see the (US) dollar appreciate aggressively in the near term, which supports investment in emerging markets. Stability in commodity markets is also a positive for emerging- market companies.” Improving earnings in emerging-market companies is another plus.
Semple argues that emerging markets are primed for outperformance. “We believe emerging-market companies are better positioned than in previous years given the majority have adapted to a low-growth environment and are meeting changing investment demands. They also have better management mechanisms in place, resulting in better earnings and profit margins.”
But investor portfolios remain badly underweight emerging markets, despite the improving outlook. “Most investors are under-allocated to emerging-market equities because they are sceptical about performance,” says Semple. “We expect this sentiment will shift as investors continue to see strong performance (from emerging markets) into 2017 and, as a result, we expect they will significantly increase their exposures,” he said.
I agree. US interest rates and the Greenback are unlikely to race higher in the next six months given comments from voting members of the US Federal Reserve that more monetary policy stimulus is needed to strengthen the US economy. Commodity prices are improving. Concerns over China appear to be receding and Chinese equities were among the best performers in the third quarter.
That does not mean emerging markets will rise in a straight line or that their recovery is assured. Persistent higher volatility is likely, particularly if expectations build that the US Fed will raise rates faster than the consensus forecast. That would lead to more money rotating from emerging markets to the US and the threat of a “capital exodus”.
Also, question marks remain over the underlying strength of China’s economy and the global economy remains fragile, propped up by radical monetary policy experiments worldwide that could have a bloody ending.
Conservative investors should look elsewhere, possibly to US and European multinationals that benefit from emerging-market growth. This is no asset class for the risk averse.
Caveats aside, the outlook for emerging markets is the best this decade. The asset class has a history of large falls – and stunning rebounds. Emerging-market equities underperformed developed-market equities by about 60 per cent over 1997 to 2001, then outperformed them by more than 100 per cent over the next six years.
I doubt anywhere near that level of outperformance will happen again. Emerging markets do not have the same tailwinds this time around, notably a once-in-a-generation commodities bull market present in the previous decade.
But the case to add more emerging-market exposure to portfolios this year, gradually and cautiously, is building for long-term investors who can tolerate higher risk.
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor 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 and accuracy of the information, with regard to your objectives, financial situation and needs. Do further research of your own and/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 Oct 13, 2016.