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Is it too late to invest in Emerging Markets?

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Written by: Emily Whiting
13/07/2017
Emerging Markets have returned 18% year-to-date, so investors may now be questioning whether there’s more mileage in the asset class. Here are three reasons why it’s not too late:

1) Attractive returns

The Emerging Market (EM) asset class currently has a yield of close to 3% (proxy MSCI EM Index) (Yield is an indication of the amount of income an investment has paid in the past).

Over the last decade there has been an emergence of a dividend culture across EM as more and more companies recognise the positive signal paying a dividend sends to investors, highlighting strong governance and capital allocation. After all, dividends should not be underestimated; the best companies grow their profits over the years and this allows them to pay higher dividends.

Companies able to achieve this tend to see their share price rise. The combination of a dividend that grows over time and a rising share price can add up to impressive long-term returns. In EMs, dividend-paying strategies provide attractive opportunity for investors who recognise they need emerging markets exposure in their portfolios but are happier with a more conservative approach to the asset class.

When we consider the asset class, some markets make more natural homes for income seekers, such as Taiwan. Companies in Taiwan tend to pay out more of their profits as dividends; the country has numerous cash flow generative businesses with management who align themselves with minority shareholders and want to pay dividends.

In contrast, a market such as Korea typically has weaker governance. The chaebol ownership structures (family run business) are complicated and means shareholders and paying dividends are not a priority. Korean companies pay out less of their profits than almost any other market globally.

2) Reasonable valuations

For investors who think they might have missed the boat already on EMs, current valuations suggest otherwise. Valuations are not demanding, with price-to-book (a measure of the share price relative to a company’s assets) still roughly 10% below the long-term average.

Investors buying EM equities at or below the current 1.65x price-to-book multiple have enjoyed 15% one-year returns in US dollars on average since 1995. Moreover, it is helpful to put the current rally in a global context: In the five years to end May, the S&P 500 outperformed EMs by roughly 90 percentage points on a total return basis. That outperformance includes the recent EM rebound.

The EMs have just started to play catch-up, and if their fundamental improvement is genuine—as we believe it is—there is significant room to narrow that performance gap over the next year or two.

3) Softening in US dollar strength

This has given EMs the breathing room to do well. After a painful bull run since 2011, the US dollar has probably nearly topped out and we are positioning ourselves accordingly for this. Currency risk is behind us, not in front of us.

EMs are certainly now much better placed to deal with a higher USD environment. Global sensitivity to the USD and the number of EM countries which require foreign capital is lower than it has been in quite some time. The current account deficits of the Fragile Five are no longer as vulnerable, making them more resilient to a stronger USD.

A final point for investors…

EMs are inherently volatile and a sell-off this year is possible, even likely. In fact, going back nearly 30 years, the MSCI EM index average intra-year drop has been 22.8% (in GBP). However, annual returns have been positive in 14 of the last 27 years.

While markets can always have a bad day, week, month or even a bad year, history suggests investors are much less likely to suffer losses over longer periods. In other words, it pays to keep a long-term perspective.

A hawkish Fed, higher USD, geopolitical instability and a decline in commodity prices are certainly some of the key areas which have faced EM economies over the past few years, causing much volatility. But with some of these headwinds subsiding, global growth rebounding and emerging markets showing signs of economic strength, investors may therefore be missing a trick by maintaining an underweight to the asset class.

While investors should brace for volatility, the prospects for emerging markets look bright.

Emily Whiting is client portfolio manager for the Emerging Markets and Asia Pacific (EMAP) Equities team at JPMorgan Asset Management  

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