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Four reasons why emerging markets are back on the horizon

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Written by: Paloma Kubiak
12/05/2016
Emerging markets are expected to grow by an average of 4.9% between 2017 and 2021 while the figure for developed markets is set at 1.9% according to the International Monetary Fund. With the recent market volatility, investors are now turning their attention to emerging markets as a source of returns.

Emerging market equities have had a rough time in recent years, with the MSCI Emerging Markets Index delivering a total return of -8% in sterling terms over the five years to the end of March.

In comparison, there was a 57% return from the MSCI World Index, says Jason Hollands of Tilney Bestinvest, and within the emerging market world, some countries have been more of a disaster than others.

But for Dr Jan Dehn, head of research at Ashmore, emerging markets now look attractive and per capita GDP will rise by 25% over the next five years, nearly twice as much for developed markets.

Here are four reasons why emerging markets are on the horizon:

1) Cheap valuations

Developed markets bared the brunt of the 2008/09 crisis and in order to restore finance, they underwent a process of purchasing assets through Quantitative Easing (QE) while interest rates were also driven to the near zero mark.

This meant that Central Banks didn’t buy a single emerging market asset, instead only buying their own country’s assets which resulted in a large scale sell off of emerging markets.

As institutional investors tend to mirror the actions of central banks, they also jumped on the QE bandwagon, says Dehn, meaning they also reduced their exposure to the non-QE markets such as emerging markets as “there was a view that emerging markets would fall under tightening financial conditions”.

Dehn adds: “The result was a giant portfolio shift whereby capital flowed into US equities and European bonds” and by late 2015, this meant currencies had fallen by more than 40% against the US dollar, making the currency competitive and assets cheap, much cheaper than developed markets.

Darius McDermott, managing director of Chelsea Financial Services, adds that more recently, emerging markets were priced for a “China hard landing” but for the long term investor, it’s probably a good time to invest: “The market has sold off a lot and valuations are better – they were priced to fail and they haven’t.”

2) Low default rates

While Dehn acknowledges there have been fragile moments in emerging markets, especially with the strong dollar and collapse of commodity prices at the start of the year, he says: “I can conclude without much ambiguity that of the 62 countries in the EM index, only two have defaulted – Argentina and Ukraine – and neither have much to do with the major markets stocks and they’re not typical of emerging markets”.

Defaults matter to the investor because they mean a country or a company can’t pay its debts. “So if you hold a bond that defaults, you don’t get your money back and defaults cause bond holders to worry that if, for example, Argentina defaults, Brazil could be next,” adds McDermott.

However emerging markets have shown resilience, and Dehn says that corporate default rates in the region never rose above long-term average default rates since 2010 and adds that they currently track well inside default rates for, say, US corporates.

3) Currency down but emerging markets haven’t lost control of inflation

EM currency has fallen in value by about 50% since 2010 while the euro and yen have dropped by about 40% against the strengthening dollar. However, Dehn says that emerging markets haven’t lost control of inflation and since July 2012, inflation has actually been lower than expected.

“The outflow of capital from emerging markets, especially in local markets, pushed yields up and currencies down all in the context of low, stable inflation”. This in turn means that external balances have improved, and a stronger current account balance means the emerging markets have been able to build up reserves, pushing up exports. As a result, this has actually led to a positive impact on GDP figures.

In contrast, the US dollar has rallied by 40% since 2011 and now with the “waning momentum”, this makes EM local markets more attractive.

4) Commodity price recovery beneficial

As emerging market countries can export as much as 40% of commodities and energy, they’ve enjoyed the strongest rebound year-to-date, says Felicia Morrow, CIO and CEO of Ashmore’s equity business.

“Year-to-date, Peru has returned 33.7%, Brazil 28.7%, Colombia 19.9% and Russia 17.5%, compared with a 0.85% return for the overall MSCI EM benchmark.

“Low prices have negatively affected these commodity/energy driven economies and contributed to the substantial fx weakness.  As prices have recovered and the US dollar has weakened, the rebound has been most pronounced in those markets that had been most pressured.”

McDermott argues that a lot of emerging markets are also importers of commodities too, especially Asia so they’ve benefitted from the falling commodity prices. He adds that there’s a “general misconception” that when commodity prices start rising, economies will do better.

“Actually it’s the other way around: once economies do better, demand for commodities will increase and their price will then recover. It’s all about supply and demand in this sector and at the moment surplus supply is still a problem for the likes of oil and gas.”

How to invest in emerging markets

Most investors should probably have a little bit of emerging markets in their portfolios, says McDermott. “They offer very different investment opportunities to those in developed markets. Most people will have a generalist global emerging market fund but if you like a particular story, there are some very good specialist funds out there – like First State Greater China, GSAM India Equity Portfolio and Aberdeen Latin American.”

See YourMoney.com’s Back to basics: how to invest in emerging markets for more information.

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