Opportunities in emerging markets

Financial Journalist
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Contrarians will lick their lips at the latest rout in emerging markets (EMs). The tapering of US economic stimulus, concerns about China and commodities, and worsening fiscal imbalances in key developing nations have smashed EM currencies and equity markets this year.

EM currencies in January had their biggest sell-off since 2009, and the FTSE Emerging Markets Index shed 9.9% in the three months to 31 January 2014. Over three years, the index has an average annualised loss of 3.7%, versus 9.7% for developed markets.

Is this savage underperformance a cheap entry point? A higher allocation of EM equities makes sense in the next 12-18 months, but a portfolio tilt now is premature. EMs are cheap for good reason – the risks of contagion across the region are rising. They will get cheaper yet, despite some much-needed stability in EM currencies and equity markets this week.

The question is not whether to buy EM equities, but when.

The bull argument

As an asset class, EMs have much to offer long-term portfolio investors, such as self managed super funds. A 2010 OECD report, “The Emerging Middle Class in Developing Countries”, predicted the global number of middle-class consumers earning or spending US$10 to US$100 daily would soar from 1.84 billion in 2009 to 4.88 billion in 2030, with Asia accounting for most growth.

Economic benefits from increased urbanisation and industrialisation, and the demographic dividend from a higher proportion of younger people in the workforce, add to the positive long-term outlook for emerging economies.

Economist Nouriel Roubini wrote in The Guardian last week: “…the threat of a full-fledged currency, sovereign debt and banking crisis (in EMs) remains low. … Over time, optimism about emerging markets is probably correct.”

A September 2013 Vanguard US white paper, “The Outlook for Emerging Market Stocks in a Low Growth World,” had a positive long-term view.

“The long-run outlook for emerging markets could still be quite positive, even if their economies grow more slowly than in the past. Further, we believe these markets have an important role in diversified equity portfolios,” that report said.

A high-growth portfolio could have a benchmark allocation of about 8% in EM equities within the international equities component, according to the ASX. That falls to 5% for a growth portfolio, 3% in a balanced portfolio, and zero in moderate and conservative portfolios.

The bear argument

A lot can go wrong. The main factors smacking EMs are unlikely to be resolved soon. Uncertainty about the speed of withdrawal of the US Federal Reserve’s quantitative easing program is a huge cloud over EMs, for it increases the risk of further fund outflows to developed markets, and currency collapses and debt defaults.

China is another risk for EMs. Should its growth slow more than expected, commodity prices will continue to slide, creating problems for developing nations that rely on commodity exports.

Moreover, the combination of slowing economic growth in EMs, worsening current account deficits, and elections in several key nations this year, is a dangerous trifecta. If developed nations struggle to implement fiscal austerity during low growth, what chance do emerging countries have to reform their economies without great pain and possible social unrest?

The Bank of International Settlements last week warned: “At some point over the next few years, central banks in the advanced economies will increase short-term interest rates and reduce their holdings of government and other bonds. How this policy shift will unfold is not known, and uncertainty about the policy path could unsettle global bond markets.”

It added: “Downward pressures on some emerging-market currencies could be accentuated, increasing the local currency cost of servicing dollar debt. Higher long-term rates, currency depreciation and more volatile markets could make even more difficult the choices emerging-markets’ central banks face on their policy rate, on the exchange rate, on the long-term interest rate and on the best use of their balance sheet.”

Long-term relative valuations are another issue. Vanguard’s white paper said: “The gap between emerging-market and developed-market valuations has shrunk considerably over the past decade, and are now fairly similar. Thus, the rising valuations in emerging stock markets have already contributed to returns. With valuations where they are today (September 2013), investors should be cautious about expecting a repeat of the past decade.”

Look for opportunities in the second half of 2014

Contrarians face a conundrum: high and rising risks in EMs this year, and a narrowing valuation gap between EM and developed-market equities in the past decade; versus the strong medium- and long-term prospects for emerging economies.

How EMs perform this year is anybody’s guess. My view is continued high volatility and further losses in the first half of 2014, followed by more stability as the concerns about the US, China, and commodity prices slowly recede.

For the next few months, the sidelines look the safest place in EMs.

Gaining EM exposure

SMSFs wanting higher emerging exposure in the second half have a choice between managed funds and exchange-traded funds. I like exchange-traded products, but prefer active managed funds for EMs. Paying for professional investors, who can deal with volatile markets, and choose the right countries within the EM basket, could be worth it.

The Aberdeen Emerging Opportunities Fund has a four-star Morningstar rating and $1.16 billion in assets under management at 31 December 2013. It had the highest ranking over five and seven years, with an annualised return of 13.5% and 7.3% respectively.

The Arrowstreet Emerging Markets Fund has also performed well over five years, with an 11.1% annual return. It also has a four-star Morningstar rating.

SMSFs that prefer exchange-traded products should use the Vanguard FSTE Emerging Markets Shares ETF or the iShares MSCI Emerging Markets ETF. The Vanguard ETF is slightly cheaper, but both are a simple, low-cost way to gain exposure to EMs via the ASX.

Listed Investment Companies (LICs) that specialise in emerging companies are another option. The AMP China Capital Growth LIC traded at an 18% discount to its pre-tax net tangible assets at December 2013. The Emerging Markets Master Fund and Asian Masters Fund traded at a slight premium.

A less-considered, lower-risk way to play EMs is through multinationals with a large and growing presence in developing countries. The iShares Global 100 ETF is an interesting idea – exposure to the world’s largest companies that benefit from growth in developed markets and, increasingly, EMs.

Source: ASX

Tony Featherstone is a former managing editor of BRW and Shares magazines.

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.

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