To say it’s been a rough ride for the emerging equity markets this year would be an understatement of sorts.
Since the start of 2013, investors investing across the group of 21 countries, which fall under the umbrella of MSCI Emerging Markets Index, have lost close to 10 per cent. By contrast the S&P 500 and the UK’s FTSE All Share Index are up 15.6 per cent and 10.9 per cent respectively.
Large outflows witnessed in the first four weeks of June—a record $19.8 billion dedicated to emerging market equity funds, according to Boston-based global data tracker EPFR—after the US Federal Reserve hinted at slowing down its stimulus programme starting later this year added to the investors’ woes. This figure surpassed the $18.7 billion monthly outflow seen in January 2008.
According to Chicago-based investment research firm Morningstar, until July 29, diversified emerging markets stock funds category had lost 6 per cent, India and Latin America dedicated equity funds had slumped 15 per cent and China region funds category was down 2 per cent. As a consolation, if at all, the diversified emerging markets stock funds category for the 12-month period was up five per cent.
Clearly, emerging markets have struggled in the past 12 to 18 months amid what is still an anaemic growth scenario in Eurozone and somewhat improving US numbers.
China’s slowdown amid transitioning to a new economic model of consumption led growth rather than one led by fixed asset investment, India’s currency depreciation and its worrying current account deficit, and Brazil’s days of riding on the commodities ‘supercycle’ coming to an end have all contributed to the disappointing scenario.
Civil and political unrest in countries such as Turkey, Egypt and Brazil haven’t helped matters and added to what is usually called a ‘risk’ premium when it comes to investing in emerging markets.
Not overly perturbed by the immediate fallout of the US Fed’s decision on gradual slowing down of the $85 billion monthly bond purchases, Raj Tanna, portfolio manager at JP Morgan Private Bank, EMEA, welcomed the announcement, adding that it was less a reflection on the emerging markets’ concerns.
“The immediate volatility [of May and June] was more a function of the tapering situation rather than the more sort of long standing kind of growth concerns, or of any sort of fundamental concerns,” said Tanna.
But continued volatility in emerging markets surrounding withdrawal of quantitative easing and gradual rise of interest rates—when it comes—is not ruled out.
“When it comes to QE and how the emerging markets reacted, in many respects it was, I believe, a short term story,” said Peter Duke, sales director of Fidelity, Middle East. “And you might get bouts of risk due to the fact the ultimately interest rates will go up and QE will come to pass. That means markets will be volatile from time to time.” Duke added that Ben Bernanke and all the Central Bank guys who matter won’t increase interest rates until economic growth is strong enough to sustain itself.
Despite the disappointing performance of the BRICS or emerging markets this year coupled with the extreme market volatility exhibited in May and June, fund and portfolio managers still favour this group in the long term.
In general, there is very much a compelling case to be made for what is still a faster growing group of emerging markets. The long-term structural drivers of global emerging markets stand intact. Rising populations and higher incomes, with their concomitant wealth effects that will include, among other things, growing consumer spending on goods and services in the decades to come make emerging market companies or those developed market companies with exposure to emerging markets an attractive investment proposition.
Also, looking at some of the current market indicators points to a case of why it’s an opportune time to get into the emerging markets equity space.
On valuation levels, today emerging markets are trading at just below 10 times next year earnings on a simple P/E basis, with the historic average being just over 12 times. Price to book basis once again is between 1 and 1.4 times, which is not far off the trough in 2008. However, some are more expensive (India is a cse in point) than others and so, picking markets and companies becomes all the more a matter of careful selection.
With emerging market fundamentals still stronger than the debt-laden developed countries, and with their attractive valuation, Edward Evans, global client portfolio manager, emerging markets equities, at Schroders, said that “if you are an investor with a time horizon of a three-year or more window, then with some comfort we can say that you are fairly well placed to be investing [in emerging markets].”
However, increasingly because of correlations between emerging markets coming down—a lot of these countries are so different [even within BRICS] and their policies varying from one other, country allocation—with newer ones with growing middle class and favourable growth potential coming into the fray—is playing a more important part in the investment process.
Also, besides macroeconomic factors, the make up of the market such as China’s state-owned enterprises, which make up 70 per cent of the index, is a key factor to be taken into account. And that means the task of investing in countries and companies need to be backed by more careful research and the buzzword among active managers, as Fidelity puts it, is ‘selectivity.’ For them as for some others, therefore groupings such as BRICS or CIVETS (comprising Columbia, Indonesia, Vietnam, Egypt, Turkey and South Africa), or some other-lettered acronym don’t work any more. There are pockets of opportunities across the 21 countries under the MSCI Emerging Markets Index, though exposure to the big-sized economies such as China, Russia and India still hold considerable appeal.
Making a case for BRIC markets, which have suffered in recent months, is Mark Mobius, executive chairman of Templeton Emerging Markets Group. He believes that the setback is temporary since the fundamentals in many BRIC companies look good.
“In Brazil, reform is ongoing as a result of public protests. In Russia, stocks are cheaper than they have been in a long time. In India, with the upcoming elections [in 2014] there will be a move to a more reform-oriented government. In China, the efforts by the government to slow down the economy and put it on a more market-oriented path will pay off in the medium term.”
On China, which is following on the lines of the US Fed’s policy of slowly withdrawing the massive stimulus and transitioning its economic model to a more domestic consumption oriented one, there is almost a consensus among managers about this qualitative change being for the good.
“We prefer to see growth moderate and come off than on the flip side see authorities throwing caution to the wind and pumping up an aggressive stimulus policy especially credit driven stimulus and getting growth back up to 9 to 10 per cent,” said Evans. “That’s not a sustainable pitch.”
However he added that the “tricky bit” is how the Chinese authorities can bring about the change: quality of growth rather than the quantity of growth.
“That’s easier said than done, when 70 per cent of the index is state owned enterprises and you got a lot of vested interests which may well be hurt by the reform measures needed to transition the model to a more sustainable basis. And so you likely to see bumps on the way,” Evans said.
While clearly there’s a slowdown in China’s growth—from the highs of 11 per cent in pre-crisis years to about 7 and 7-1/2 per cent these days—JP Morgan Private Bank’s Tanna welcomes what he essentially sees as a measured rebalancing of the economy.
“So you sort of move from fixed investment being two thirds of GDP down to a third of GDP, which is around the norm in developed world economy,” said Tanna, adding that the bank’s preference within emerging markets has been towards Asia.
To that extent, Arjuna Mahendran, chief investment officer at Emirates NBD Wealth Management, is quite optimistic that this current tightening cycle that is also being seen in the BRICS economies, which is extending into places like Indonesia and creating this currency volatility will eventually turn into a loosening cycle within the next 12 to 18 months.
“That is really going to be the big growth story over a five-year horizon,” said Mahendran.
Brazil, which has thrived and flourished on the back of the commodities boom, is heavily reliant on commodity demand from China. That does not help its growth story. And now with the sort of inflationary problems and unemployment or flexibility of labour market issues, makes the case for investing there all the more harder, according to some managers.
“So our preference would certainly be towards Asia,” said Tanna.
Within Asia, India’s political gridlock is what is really holding growth back. With the growing population, five and a half per cent GDP growth, in many instances, feels like a bit of a recession, according to some experts.
“If you look at all the times that India as a country has done well from an economic standpoint you have always seen reforms that preceded it,” said Duke. “And you have not seen reforms now—you have seen talk of reforms, a couple of things pushed through but by and large, there’s a political deadlock. That’s holding back the economy and therefore the stock markets.”
This is not to say that India does not offer opportunities.
“India obviously in terms of foreign investment has been quite difficult a market,” said Tanna. “But you can see it opening up. But to an extent the factors are the same there in terms of needing good stock picking within the constraints that you have got as a foreign investor into India.”
Issues of corporate governance and transparency are an important aspect when investing in emerging markets. Managers say while some have improved, others have gone backwards.
“I think generally speaking in the previous decade, there was a case corporate governance improved a lot. Now their growth is slowing and when the things are not as positive, corporate governance is in some cases taking a back seat,” said Fidelity’s Duke. “[In this regard] you have got to be very careful when you are investing in emerging markets.”
While agreeing that corporate governance has been improving in emerging markets generally, but keeping that in mind, for example, in Russia, Evans said that they tend to prefer those companies which are being managed with the benefit of minority shareholders in mind.
