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Flanders: It’s a bad time to be underweight emerging markets

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Written by: Paloma Kubiak
08/04/2016
The world has changed since January 2016 as the strong dollar, falling commodity prices and serial poor performance by emerging markets have all gone into reverse. It’s too soon to say whether this will last but it does present some opportunities for investors against the backdrop of the impending Brexit referendum.

For Stephanie Flanders, chief market strategist for Europe at JP Morgan Asset Management, it’s “probably a risky time” to be underweight in emerging markets. Meanwhile she adds that it “makes sense” to be overweight in equities and for active investors, they “don’t want to be” underweight in commodities.

At the launch of the Guide to the Markets for the second quarter of 2016, Flanders also says that while she shares JP Morgan’s view in favour of remaining in the European Union, “the economic consequences of Brexit are overstated on both the cost and benefits side,” and the truth is that long-term, we “just don’t know” what the impact will be for investments.

Emerging markets

While Global emerging markets (GEM) have boomed over the last 15 years, they had a tough 2015 as the MSCI Emerging Markets Index fell 8% and economic growth fell to its slowest pace in six years.

China also dominated the headlines as it reported its slowest growth in 25 years in 2015 and it used the circuit breaker tool twice in the first trading week of 2016. As such it’s no wonder investors have gone cold on the GEM region as a whole.

But for JP Morgan, GEMs are back on the radar as the US dollar has weakened and commodities have stabilised.

“Emerging markets still have work to do improving their economic fundamentals, and the dollar could strengthen again later in the year, if investors revise up their expectations for rate increases in the US. But for active investors, it’s probably a risky time to be underweight in emerging markets.”

Flanders adds 2016 will be better year for GEMs which could result in double digit returns.

Indeed she adds that compared with Europe, the US and Japan, a greater number of GEM companies offer dividend yields of greater than 2%. For investors who are more cautious on earnings expectations, using GEM equity stocks for income generation until capital appreciation comes into play “could benefit portfolios,” she says.

JP Morgan recommends a highly selective, bottom-up approach to emerging market equities as a good way to start adding exposure. “These equities can also be a good source of yield for income-hungry investors as they wait for fundamentals to improve and earnings to turn up.”

Brexit

A Brexit is currently one of four concerns for JP Morgan, along with the weakening service sector, activity in the US and Europe, bond market turbulence created by changing US inflation, and interest rate expectations.

Flanders anticipates a vote to remain in the EU and adds if the UK does vote to leave, the long-term consequences are “possibly overstated by both sides of the debate”. However she adds the short and medium-term outlook could be “very messy indeed”, with one impact being a halving of UK economic growth.

She says: “Rather than growing at about 2% a year the UK would probably only manage about 1% growth for a few years, as uncertainty around the eventual outcome of negotiations about the UK’s future relationship with the EU may discourage or delay investment and trade.” All other things being equal, she says this would mean interest rates would go up less quickly and sterling would fall perhaps quite significantly.

“However longer-term, the microeconomic impact of a Brexit will be more important than the macro, with investors needing to consider carefully how individual sectors and companies are positioned for the new environment,” she adds.

Looking at the statistics, Flanders says Britain is one of the top five economies in the world so it shouldn’t be “that difficult if we leave” but politically it would be “significant”.

Commodities

Over the past 18 months, a key market trend has been falling commodity prices. However this was reversed in the first quarter of 2016, and Flanders says active investors may want to re-think being underweight in the sector.

Even oil prices are showing signs of stabilisation as production growth in Saudi Arabia, Russia and the US has stalled. However there are continued signs of oil demand growth as consumers take advantage of lower prices.

After five years of negative returns for the commodities sector, if we are beginning to see supply falls, or at least some stability, and demand continues to grow at its current pace – JP Morgan “would expect to see commodity markets rebalance and commodity-related equities re-rate from very depressed valuations”.

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