Is the fall in emerging markets a buying opportunity?

Rising interest rates in the US, and escalating trade tensions between the US and China have led to investors pulling out capital from emerging market assets. And many emerging market currencies, most notably those of Turkey and Argentina, have come under pressure.  

“The biggest issue has been the strong dollar,” says Austin Forey, manager of JPMorgan Emerging Markets Investment Trust (JMG). “That pushes up US government bond yields so people see less need to move into riskier assets. A strong dollar also raises the bar on interest rates, and this in turn has an economic and profit impact on companies [as it increases the value of US dollar denominated debt and the servicing of that debt]. It’s not the first time we have been round this cycle. It’s not terminal, though it’s certainly not agreeable.”

A slowdown in China’s growth and across emerging markets more generally has also knocked investor confidence. Chinese gross domestic product (GDP) expanded at an annualised rate of 6.7 per cent in the second quarter of 2018, compared with 6.8 per cent in the previous three quarters.

“Emerging market economic growth has decelerated since the beginning of the year from 5.8 per cent year on year in the fourth quarter of 2017 to 5.3 per cent year on year in the second quarter of 2018,” reports Morgane Delledonne, ETF investment strategist at BMO Global Asset Management. “Purchasing managers' indices - surveys on economic activity - have lost momentum while staying above the expansion threshold."

Attractive valuations and long-term growth

But the falls in emerging market equities' valuations could also present opportunities. "Emerging markets corporates’ earnings are high compared with prior cycles’ peaks, while equity valuations are close to multi-year lows," says Ms Delledonne. "Emerging market equities are about 30 per cent cheaper than developed market equities, based on relative long-term price/earnings ratios.”

She is cautiously optimistic because she believes the sell-off has been overdone and that for investors who can afford to take a long-term approach this could be an attractive entry point.

"The cheaper things get, the more interesting future returns look,” adds Mr Forey.

One area in which he is finding opportunities is Indian financials, a sector that includes well-run businesses with strong growth potential that are cheaper than a few months ago.

“[Long-term growth will come] from emerging markets, both in terms of population growth and GDP per capita," says Gary Potter, co-head of multi-manager solutions at BMO Global Asset Management. "And the amount of global indices that emerging markets account for will continue to go up, so people need to have some exposure to that.”

The economic headwinds that have buffeted emerging markets this year may lessen, especially if the US dollar weakens.

“US growth has been very good this year because of the tax cuts that were introduced at the beginning of the year,” says Bill McQuaker, manager of the Fidelity Multi Asset Open funds. “The impact of that will peak in the fourth quarter of this year, so as a positive force that’s going to fade. And short-term interest rates in the US have gone up 75 basis points [in the past year] and look like they are heading towards 3 per cent in 2019. All those are headwinds for US growth. There are already some signs of this such as housing and autos sales slowing.”

In such an environment, Indian equities could offer good growth opportunities because the country has a young population and is undergoing a structural reform programme. It is also relatively insulated from the slowdown in China.

“The linkages between India and China are not that many compared with those between the latter and Latin America which exports commodities to China, and south-east Asia which assembles many of the components used in Chinese goods," explains Mr McQuaker. Also, India is not a major destination for Chinese tourists, so it’s quite immune to China.”

Some Latin American countries may also offer interesting opportunities, according to Ilan Furman, portfolio manager, global emerging market equities at Columbia Threadneedle. “While [Brazilian] election uncertainty is high, the country’s macroeconomics and corporate sector are in good shape – especially compared with two or three years ago,” he says. “Brazil’s corporate sector has many high-quality companies with strong balance sheets and strong market positioning. This has led to high structural profitability and attractive dividend yields. Several companies in Brazil are exposed to secular growth, where trends are driven by factors such as lower banking penetration and labour force formalisation. This is resulting in high growth in sectors such as asset management and insurance, and digitalisation of the retail sector, reflected by high growth rates of digital payments companies.”

Global headwinds

If the US dollar continues to strengthen it would be bad news for countries and companies that hold US dollar-denominated debt. Sheridan Admans, investment manager at The Share Centre, says: “So far, the situations in Argentina and Turkey have not created a contagion effect, but there is the potential for things to get worse, for example due to a liquidity crisis if the US has to tighten interest rates more quickly than expected.”

And India is vulnerable due its current account deficit. “India has a negative balance of payment situation, which means it imports more than it exports, so it needs foreign investors to invest their capital in it," says Mr McQuaker. "If those investors don’t, it will slow demand. The red flags in Turkey and Argentina were currency weakness [indicating] foreign capital was not invested in [those countries]. And in India, the currency has been really quite weak.”  

China’s slowing growth is a concern across several emerging markets. And the trade tensions between China and the US will either result in a trade deal between the two economic powerhouses or a trade war. Either outcome will have a strong impact on sentiment towards emerging market equities.

“The International Monetary Fund (IMF) has estimated that the drag could amount to 0.5 per cent by 2020 if the tariffs threatened by various trading partners are all implemented," says Ms Delledonne. "In such a pessimistic scenario, where the US cannot negotiate a trade deal with China, we would expect a correction in US equities as market participants realise that it could be a lose-lose situation. The possible rise in US inflation may force the Federal Reserve to increase interest rates more aggressively than anticipated, which would be likely to be disruptive for markets globally.”

Funds for emerging markets exposure

If you have a long-term investment horizon, some exposure to emerging market equities makes sense given their growth potential. But Mr Potter is waiting for some easing of the trade tensions between the US and China before he buys further into emerging markets. And he prefers accessing the asset class through broad funds that invest across several markets, rather than single-country funds.

He likes Hermes Global Emerging Markets Fund (IE00B3DJ5K90), whose investment team is led by Gary Greenberg. It aims to invest in quality companies that generate a high return on equity, have strong balance sheets and attractive valuations. Its managers pick stocks according to their individual merits, but also pay attention to the impact wider economic conditions can have on companies. They also consider environmental, social and governance factors in their analysis.

The fund has a strong record of outperforming MSCI Emerging Markets index, and is one of the best-performing funds in the Investment Association (IA) Global Emerging Markets fund sector over three and five years. Its largest single country exposure is China, which accounts for 35.5 per cent of its assets, followed by India, which makes up 13.9 per cent. Information technology is the largest sector exposure, accounting for more than a third of the fund's assets. Hermes Global Emerging Markets has an ongoing charge of 1.12 per cent.

Mr Potter also likes Artemis Global Emerging Markets (GB00BW9HL132), a relatively new fund that has been running for three-and-a-half years. Over three years, it has made 55 per cent, compared with 41.6 per cent for MSCI Emerging Markets Index. It is also in the top quartile of the IA Global Emerging Markets sector over one and three years.

The fund aims for good long-term returns through a combination of capital growth and income. It has a yield of about 2 per cent and an ongoing charge of 0.9 per cent. The fund has been managed by Peter Saacke and Raheel Altaf since launch. They look for companies with strong earnings growth and consistent upgrades to their forecast profits, and which benefit from macroeconomic trends. They prefer investing in temporarily unpopular companies trading on below-average valuations.

For investors who want specific exposure to India, Mr Admans suggests Jupiter India (GB00BD08NQ14). This fund is run by Avinash Vazirani, who has more than two decades’ experience investing in Indian equities and has developed a strong track record. According to FE Trustnet data, Mr Vazirani has delivered a return of 165.3 per cent over 10 years, compared with 142.5 per cent for a composite of his peer group.

He invests via a ‘growth at a reasonable price’ investment style, and seeks companies he believes are the best in their fields and can benefit from structural trends. These include the rising spending power of India's middle class and the transition of the country's informal economy towards a formal economy, as increasing numbers of people have bank accounts. Financials are the fund’s largest sector exposure accounting for 23.3 per cent of its assets, followed by consumer goods at 22.7 per cent. The fund has a bias to large-cap companies which make up almost 60 per cent of its assets.

Mr Admans also likes Goldman Sachs India Equity Portfolio (LU0858290173). “The difference between this and the Jupiter India fund is that there is more of a team approach at Goldman Sachs,” says Mr Admans. “Goldman Sachs also has a bit more of a global reach.”

When selecting holdings, Goldman Sachs India Equity Portfolio's managers evaluate the attractiveness of a company's industry, and generally ignore capital-intensive industries with low returns. They then assess the company's valuation. They aim to invest in sound businesses with strong cash flows where they see the opportunity for a substantial gain. Financials account for 21.7 per cent of Goldman Sachs India Equity Portfolio's assets and information technology accounts for 17.9 per cent. The fund has an ongoing charge of 1.09 per cent.

For exposure to Brazil, Mr Admans uses Neptune Latin America Fund (GB00B909HH53), which has 55 per cent of its assets in Brazil and 25 per cent in Mexico. The fund's manager, Thomas Smith, aims for capital growth by seeking investments across Latin America. The fund is substantially overweight consumer discretionary companies, which account for 17.5 per cent of its assets, in contrast to just 4.4 per cent of its benchmark, MSCI Emerging Markets Latin America index. The fund also has 11.4 per cent in utilities, compared with 4.3 per cent for its benchmark and 34.6 per cent in financials, compared with 29.8 per cent for its benchmark. But it is underweight consumer staples, communication services and energy companies. Neptune Latin America has an ongoing charge of 1.09 per cent.

Performance

Source: FE Analytics, as at 12/10/18