Following an extended period of underperformance relative to the likes of the UK and US, emerging market equities have rallied strongly this year with the MSCI Emerging Markets index returning more than 15 per cent since sentiment bottomed in March.
Performance of indices in 2014
Source: FE Analytics
Though there are a number of potential headwinds facing the developing world such as slowing growth and the end of QE – tied in with the prospect of higher interest rates – Higgins, chief markets economist at the group, says the recent rally is no dead-cat bounce.
“We think this outperformance is set to continue,” Higgins said.
“Admittedly, the prospects for growth in emerging markets and Fed policy continue to be seen by many as reasons for caution. But while growth has clearly slowed, the big deceleration in the BRICs has probably already happened.”
“And if history is a useful guide, a rout is by no means a foregone conclusion once US rates begin to rise.”
“What’s more, equity valuations are generally lower in emerging markets than in developed markets. Granted, volatility remains low despite plenty of potentially destabilising events. But we suspect that if these began to have more of an impact, any correction would only be temporary.”
There have been multiple contributing factors as to why emerging markets have underperformed their developed rivals over the last three years.
One of the most recent of those, which caused the asset class to plummet last year, has been the US Federal Reserve’s plans to reduce its quantitative easing programme and eventually tighten monetary policy by raising interest rates.
The initial taper at the turn of the year caused emerging market equities to fall due to concerns about how the reduced stimulus would affect countries with current account deficits, most notably the so-called fragile five of Turkey, India, South Africa, Brazil and Indonesia.
Though Higgins accepts that a raising rate environment in the US could have a negative impact on emerging markets, he says fears surrounding such an event have been over-done.
“There have been three major Fed tightening cycles in the past quarter of a century,” Higgins explained.
“The return from emerging market equities in the 12 months after the initial was very poor, in US dollar terms, in the first case. But in the other two, it was very healthy.”
The first case was in 1994, when former Fed chairman Alan Greenspan spooked the market by unexpectedly rising interest rates.
According to FE Analytics, the average fund in the IMA Global Emerging Markets sector fell by more than 20 per cent that year.
Performance of sectors in 1994
Source: FE Analytics
The other two tightening cycles were in 1999 and 2004.
Emerging markets funds delivered double digit returns in each of those years, according to FE Analytics.
Higgins says that the events of 1994 are unlikely to be repeated as the market has had 12 months of getting used to the idea of tighter monetary policy and therefore it is no longer going to be an unexpected event.
Paul Niven, head of multi asset investment at F&C and Foreign & Colonial Investment Trust manager, is much more bearish on emerging markets.
“It is still a little too early to become more constructive on the emerging markets, even though fundamentals for the ‘fragile five’ are improving and the case for investment has improved,” Niven said.
“The brighter performance of emerging stocks this year has, in part, been a function of falling US bond yields. However, the re-acceleration of US growth combined with slightly higher inflationary pressures should see yields rise again and staunch the recent flow of capital into the emerging markets.”
“We also remain wary that the structural challenges facing emerging markets will once again resurface to unsettle investors later in the year.”
Ben Willis, head of research at Whitechurch, says that though the short-term outlook for emerging markets is likely to be volatile, investors should only be buying funds in the sector with a multi-year horizon in mind.
“You have to take a long-term view because it is always going to be a volatile asset class, no matter what,” Willis (pictured) said.“We believe in the long-term growth story, but these structural reforms, like China changing its whole economic model, aren’t going to happen overnight. We’ve always been structurally overweight emerging markets, but we are more neutral over the short term.”
“Yes, valuations are supportive, but we all saw what happened in January when dollar liquidity was withdrawn.”
Willis also says the reason why emerging markets have roared back is because they were trading at such a low level, compared to developed markets, that it was more of a “relative value play” than anything else.
Though he thinks investors are right to be adding to their exposure now, he says emerging markets will always be worst hit during periods of negative sentiment.
Nevertheless, Willis is willing to ride out the volatility in search of high long-term returns.
The two main portfolios he uses are JPM Emerging Markets Income, for more core exposure, and the Templeton Emerging Markets Investment Trust for his higher risk clients.
The JPM Emerging Markets Income fund, which is managed by Richard Titherington, has been a second quartile performer in the IMA Global Emerging Markets sector since its launch in July 2012, but it has slightly underperformed against its MSCI Emerging Markets benchmark over that time.
Dr Mark Mobius’ Templeton trust has a much longer-track record.
The manager’s value-orientated strategy has meant the closed-ended fund has significantly outperformed the index over the last 10 years, but that approach has meant it has struggled recently as sentiment has been poor.
Performance of trust vs sector over 10yrs
Source: FE Analytics
JPM Emerging Markets Income has a yield of 5.21 per cent and has an ongoing charges figure of 0.93 per cent.
Templeton Emerging Markets isn’t geared and is trading on a 10 per cent discount to NAV, which is wider than its one and three year average. Its ongoing charges are 1.29 per cent.
