Performance of indices over 10-yrs
Source: FE Analytics
In spite of this, the MSCI Emerging Markets Index’s outperformance has faltered since 2011, weighed down by weak growth in the developed markets, fears of a hard landing in China and the resultant emerging market earnings downgrades.
From a top-down view, many emerging markets are cheap relative to the US and Europe. We think that an active, bottom-up stock-picking approach will deliver the best returns. We do not invest in China, Brazil or Turkey per se, but in Chinese, Brazilian and Turkish companies, as we believe it is not enough to get the trend or theme right; rather stock picking is paramount in driving returns.
The wrong stock picks in a bull market could sink an investor as surely as the right stock picks in a bear market.
Apart from a short period in 1999 and the onset of the financial crisis in 2007/08, emerging market equity investors have benefited from a wide differential between emerging market and developed market price/earnings (P/E) ratios.
Since the financial crisis, these have converged, but emerging market P/E ratios are still lower than developed market ones. This convergence can in part be attributed to an increase in emerging market labour costs.
However, emerging markets still benefit from cheaper labour relative to developed markets.
Consensus would broadly hold that economic prospects in the emerging world look brighter than those of the developed world in both the medium- and longer-term. We would not disagree.
Indeed, emerging markets are now driving economic growth, with approximately 80 per cent of global GDP growth coming from the emerging world.
We would, however, caution that the correlation between growth and stock market performance in emerging markets is complex, as the composition of stock markets often bears only a very loose relationship with the economies they supposedly represent.
We believe emerging markets’ valuations are currently attractive compared with historical levels and do not show signs of being stretched.
From an asset-allocation point of view, most emerging market allocations tend to go into global emerging market-type strategies, or even passive proxies such as the emerging market ETFs.
With these approaches, the seven largest markets, which we define as markets with greater than a 5 per cent weighting in the MSCI EM Index, dominate portfolio exposure because they account for nearly 80 per cent of the MSCI EM Index.
Therefore, we believe that the bulk of equity investment that goes into emerging markets as an asset class ends up going to these seven countries: the BRICs (Brazil, Russia, India and China), South Africa, South Korea and Taiwan.
There are 21 countries in the MSCI EM Index, so beyond the seven largest there are 14 smaller emerging markets, such as Chile, Indonesia, Thailand and Turkey, that receive very little dedicated investment capital.
We attribute much of the MSCI EM Index’s underperformance over the last few months to the weakness of the BRIC markets, which has weighed on the benchmark.
Performance of indices over 6 months
Source: FE Analytics
Both Brazil and Russia, whose economies are dependent on resources, have been impacted by weak commodities markets.
Indian weakness earlier in the year, due to perceived government vacillation and currency weakness, was offset after the Indian National Congress party, against all expectations, announced a significant reform package. Meanwhile, China was hurt by fears of a hard landing.
Markets that have seen strong performance year-to-date, such as the ASEAN countries (Indonesia, Malaysia, the Philippines and Thailand), Turkey and Egypt, have been unable to make an impact due to their smaller weighting in the benchmark.
The clear divergence in the performance of individual emerging markets underlines the mixed nature of the asset group and the need to differentiate between countries on a macroeconomic level and individual stocks within those countries.
We believe that emerging markets equities offer significant opportunities to generate outperformance for active managers who are benchmark-cognisant rather than those who hug the benchmark.
In conclusion, we believe that emerging markets continue to provide opportunity and that there is still relative value in the asset class.
Historically, a key driver to the amount of money made from an investment is the price paid on entry – so with valuations at relatively low levels, we believe this creates an excellent entry point in to emerging market equities.
However, it is necessary to have a strong bottom-up investment process to make the most of it. This requires looking through sometimes beguiling headline statistics and concentrating on seeking to buy good-quality companies at attractive valuations.
Archie Hart manages the Investec Emerging Markets Equity fund. The views expressed here are his own.