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Emerging Markets: a falling knife

The leading emerging markets index is already cheap, but investors should hold off buying for now
Emerging Markets: a falling knife

It's all getting rather ugly in emerging stock markets. Since the start of 2014, the MSCI Emerging Markets (EM) index - which covers equities from 21 developing economies - has fallen by as much as 6.6 per cent. By contrast, the mature-country MSCI World index is only off by 3.5 per cent or so.

Emerging woes

Of course, emerging equities had been struggling well before this latest bout of weakness. The MSCI EM index has delivered a miserable total return of minus 13 per cent since May 2011, while the MSCI World index has surged by more than 27 per cent. And, there’s a big risk that this rotten run will continue.

Rising rates

Capital has been gushing out of emerging markets rapidly of late. Investors have been switching out of equities and bonds in these nations and into rival assets in the West and Japan. With currencies such as the Turkish lira, Russian rouble and South African lira dropping sharply, the authorities in these nations may have to hike interest rates to lure investors back, but stifling economic growth in the process.

Things may well get worse before they get better. The ongoing pick-up in the US economy is likely to prompt the Federal Reserve to cut back further on its dollar-printing and bond-buying scheme. As US bond yields rise and the dollar strengthens, the more powerful the forces against emerging market currencies and other assets become.

Better shape

One danger is that the recent turmoil could become a full-blown emerging markets crisis, such as that of the late 1990s. Back then, numerous Southeast Asian countries suffered plunging currencies following a speculative investment boom in which those nations amassed large foreign debts. The MSCI Emerging Market index suffered a greater than 60 per cent fall amidst the carnage.

However, there are some differences between conditions in Emerging Markets then and now. As a whole, EMs have greater currency reserves and have stacked up fewer dollar debts than they had back then.

EMs are already cheap

Another important difference is valuation. The MSCI EM index was richly rated going into the '90s crisis, on a trailing price/earnings multiple of 19 times. Today, by contrast, it trades on just 10.8 times. It is therefore somewhat cheap by past standards, rather than screamingly so.

The long view

Beyond the present shakeout, EMs' future still looks fairly promising. In many cases, they have younger workforces, higher growth potential and lower indebtedness (see chart).

EMs' lighter debtload

This is the opposite of many developed world economies, especially in the eurozone and Japan. Governments in mature markets are not only creaking under debt loads several times greater than those of EMs, and they have also made huge, unfunded healthcare and pension promises for the future to their ageing populations.

Follow the trend

A simple way to boost returns and lower risks when investing in EMs is to follow a systematic approach. My straightforward model involves going long when the MSCI EM index shows enough positive momentum or when it rebounds from very beaten up levels. When the EM goes into reverse, the model switches into cash invested at the three-month US risk-free rate.

Our model vs buy-and-hold

The real value of this approach is skirting the biggest falls in EMs over time. As a result of doing so, it would have made a 19.3 per cent annualised return since 1988, compared to 8.9 per cent for buying and holding. And whereas buy-and-hold suffered a 60 per cent drawdown at point, the model’s worst peak-to-trough loss of value was just 24 per cent.

(%)Trendfollowing modelBuy-and-hold
Return (ann.)19.38.9
Volatility (ann.)6.610.4
Worst drawdown-24-64
Months when best strategy4159

The drawback of this approach is the higher trading costs involved. It has required an average of 2.5 round-trip trades every year since 1988, slightly more than half of which were losers. The most recent signal was a 'sell' in December. Until this changes, the MSCI EM index is best left alone.

Of course, there may still be a case for considering individual emerging markets in the meantime. In the next section, a leading asset allocator, Christopher Aldous of Charles Stanley Pan Asset, discusses why and how we might buy into China. And you can watch my recent video on this subject here:

New paths into Chinese shares

China can be an exciting place to invest. Had you bought into the Hang Seng China Enterprise index 15 years ago when the FTSE 100 reached its all-time high, you would have made a return of more than 690 per cent. The FTSE made you only 54 per cent over the period, all of it due to dividend payments.

PE 2014EPS growth (%)Price/BookDividend Yield (%)
MSCI China8.
S&P 50015.5102.71.9

That may seem hard to believe at the moment. Most commentary about China is negative and few recommend investing there. Over the past three years, Chinese shares have become steadily cheaper in relation to Western markets, despite China’s higher rate of growth. In recent weeks, they’ve dropped more than 10 per cent and stand at a substantial discount to US shares on most measures.

If you do decide to take the leap and invest in China, how best to get exposure? Chinese companies are quoted in Hong Kong (H-shares) and on mainland exchanges such as Shanghai (A-Shares). UK investors now have greater freedom to invest in renminbi-denominated shares through exchange-traded funds tracking the local indices than they did before.

Next, do you want to invest in the large companies, represented by the China 25 Index, or do you want a broader index with a wider range of companies? The CSI index offers exposure to 300 companies, the FTSE A50 to 50 companies, and the China 25 to just 25, as the name implies.

These various indices give you exposure to rather different sectors. For example, the A50 share index has a much higher weighting in financials of around 60 per cent, compared to only 30 per cent in the broader index which gives you greater exposure to industrial and consumer stocks. The former’s exposure might thus be a concern in light of worries about the Chinese bank sector.

At Charles Stanley Pan Asset, we have in the past mainly invested through the China 25, but see the new A-share ETFs as a good development. The big difference is that they allow outsiders to invest alongside the domestic Chinese through an ETF which has physical replication. In the past, buying mainland A-shares meant buying a synthetic ETF, with the associated counterparty concerns.

Hong Kong-based H-shares do have some advantages as they reflect what international investors are thinking and have been outperforming the A-shares recently. But when the locals begin to buy their market, A-shares are the place to be.

You do, however, need to watch out for retrospective tax charges which can be levied on the A- share trackers by the Chinese authorities (the SAT), but at least the new ETF providers are holding back some of the profits and dividends against potential future taxes.

As a final thought, investing in China brings the advantage of exposure to the renminbi which tends to be a strong currency and is unlikely to suffer in the way other emerging market currencies have. Over the long term it may well appreciate further against Western currencies, providing an additional source of return.

Christopher Aldous is chief executive of Charles Stanley Pan Asset