Cover story: Are emerging markets the next wildcard investment?


Famously Warren Buffett once said that when it comes to investing “be fearful when others are greedy and greedy when others are fearful”.

If the Berkshire Hathaway boss is to be taken literally, then now really could be the time to have a rethink over emerging market equities, given the poor sentiment engulfing the asset class in the wake of the battering it has endured.

It is easy to see why the sector has become something of a pariah in the investment world, given that over the five years to 23 March, while the MSCI World index has soared by 59 per cent, the emerging markets MSCI index has fallen by 5 per cent – a steep 64 per cent differential.

During that period, the Investment Association’s Global Emerging Markets sector and the typical investment trust focused on the region have each notched up a 4 per cent loss. The tough environment has seen discounts on some developing market trusts widen to about 30 per cent, while the Association of Investment Companies sector is on an average discount of close to 13 per cent.

But while emerging markets have their own unique set of issues that tend to plague progress and investment returns – not the least of them political risks and poorer levels of corporate governance – recent years have thrown them a fresh volley of curveballs.

The latest problems have typically stemmed from China, the world’s second largest economy and therefore a major cog in the global economic engine. Its government’s efforts to move it away from being an exports and investment-led economy to one driven by consumption and services has walloped its emerging market peers. This is primarily on the back of its lower appetite for commodities, the prices of which – most notably oil – have tumbled.

While China’s economy still grew by 6.9 per cent in 2015, compared with 7.3 per cent in 2014, this marked its poorest growth rate in a quarter-century.

The backdrop has been the values of many commodity-dependent emerging market corporations plummeting. The likes of Russia and Brazil have been significantly hit by the lower commodity prices, given they are key exporters of both. Brazil, a nation heavily dependent on its energy exports and home to oil giant Petrobas, saw its stockmarket collapse by 38 per cent in 2015.


Poor global economic growth has also left international trade in a lacklustre state, which has hurt companies’ earning power and, naturally, their stock prices.

When the US Federal Reserve decided to raise its key interest rate in December, its first hike in almost a decade, the expectations among economists were that US policymakers would continue to tighten, potentially in a more aggressive manner.

This led to continued strengthening of the dollar, which for emerging markets is never a good thing, given most borrow in the greenback and it happens to be the currency commodities are priced in.

Pundits were expecting the Fed to instigate about four more interest rate hikes in 2016. However, anxieties over the strength of the US economy began to grow on the back of some poor economic data released in February, which showed the first drop in service-sector business activity since October 2013.

Additionally, US GDP expansion in the fourth quarter of 2015 was just 1 per cent, well below the 2 per cent achieved in the third quarter and 3.9 per cent in the second.

To make matters worse, in January crisis lender the International Monetary Fund lowered its global growth forecasts for 2016 and 2017 by 0.2 percentage points to 3.4 per cent and 3.6 per cent respectively.

This all conspired to ensure that the beginning of 2016 turned out to be one of the worst calendar-year starts ever for markets.

In March, however, the Fed left rates unchanged and, importantly, lowered its projections for the pace of future rises, which in turn gave dollar-indebted emerging markets something of a break.

“Companies are producing exciting growth but it is very much a stockpicker’s market”

What now?

Given that expectations of more robust rate rises in the US have gone by the wayside, the chilly sentiment towards emerging markets appears to be thawing. Tilney Bestinvest managing director Jason Hollands admits that while he has been very cautious on emerging markets for some time he does believe the market could be approaching a point where it could represent a “wild card” opportunity.

He says: “The previous focus has been on the Fed raising rates and the strong dollar. With the US economy now stalling, expectations of a ‘normal’ cycle of US rate rises are evaporating. I would feel more comfortable investing now in emerging markets than I have in the past few years.”

Notably, a Bank of America Merrill Lynch fund manager survey showed that while managers are nearly two standard deviations more underweight or short emerging markets, relative to historical average, there has been a fairly sizeable closing in that underweight from January to February.

Additionally, following the disastrous start to 2016, developing markets are ahead of their developed counterparts year-to-date, with the MSCI Emerging Markets index up 8 per cent versus 3 per cent from the MSCI World benchmark.

Looking ahead, Neptune emerging markets fund manager Ewan Thompson concedes it is difficult to know exactly when the macro backdrop will finally change in emerging markets’ favour. However, he adds: “There are plenty of opportunities out there, but also plenty of risks. For investors with a medium-to-long-term time horizon, we believe there is a huge degree of upside from here.”

Kames Capital chief investment officer Stephen Jones believes there are two factors right now that are favourable for the sector, namely valuations and positioning. He sees the latter as very underweight, while he expects the former to continue to improve. As a result, he feels it is worth “looking carefully at emerging markets”.


For his part, Henderson multi-manager James de Bunsen has been ticking up his allocation to the asset class. While he already holds the currently soft-closed Stewart Investors Global Emerging Markets fund, he has also been adding to the iShares MSCI Emerging Markets ETF. He says: “Given that sentiment has been so negative and emerging markets have performed so poorly compared to developed countries, we do see a buying opportunity.”

There is some evidence too, albeit marginal, that there has been a steadying in the commodities market. The lesser-known CRB Rind index, which follows raw indust-rial and scrap that is heavily used in industry, is up by more than 8 per cent so far this year. This is significant given that the index has no derivatives or futures associated with it. It is simply based on supply and demand. In addition, the oil price has come off the floor too. After slumping to $28 a barrel, Brent crude has moved back to the $40 mark.

The long-term story remains

While no one seems to be denying that in the short term things could get worse, given the demographics that emerging markets collectively enjoy, it would be foolhardy to discount their long-term potential. The BRIC quartet of Brazil, Russia, India and China not only boast 40 per cent of the world’s population but are also home to a plethora of natural resources. As these nations grow and consumer spending swells, shares across these regions are set to gain more traction.

Chase de Vere chartered financial planner Patrick Connolly believes that despite the recent woes the long-term story remains largely solid, especially as growth in emerging markets continues to beat that in the western world. He adds: “Economic prospects should benefit from greater  domestic consumption over time as populations there have increasing levels of wealth and disposable income.”

Hargeaves Lansdown senior analyst Laith Khalaf highlights that while China’s middle class was estimated at 50 million some six years ago, it is now forecast to rocket to half a billion people by 2020, which he says presents “a huge opportunity for those companies looking to service these consumers”.

Where are the opportunities?

Investment Quorum chief investment officer Peter Lowman has been adding at the margins to emerging markets and he too believes that for investors with a robust appetite for risk, there is a buying opportunity. He says: “There are quite a few companies generating exciting growth but it is very much a stockpicker’s market.”

Lowman asserts too that investors need to remember emerging markets are a very diverse set.

India is a case in point, as despite the headwinds, sentiment is stronger there following the landslide victory of President Modi in 2014. In addition, India has fared relatively well as its economy appears to be thriving, and as a huge fuel consumer it has benefited from a lower oil price. Over the past two years shares have surged by 28 per cent.

Lowman highlights that he has recently added the Baring Emerging Markets fund to his buy list. Co-manager of the fund William Palmer asserts that he has seen some “really attractive valuations in some high-quality companies”. He has some 30 per cent of the fund invested in  China and favours the e-commerce groups of the “new-China”, such as online marketplace Alibaba.

Palmer says: “The demographic profile is still quite young at 20 to 40 years old, and while retail sales are growing at 10 per cent per annum, online sales are nearer to 20 per cent. We always look at under-penetrated markets and there are plenty of opportunities at a stock level in China that are immune to the economic cycle.”

He cites as an example Sunny Optical, a major manufacturer of lenses, which are used in car rear-parking cameras as well as phones. Palmer says: “[Sunny Optical] is already number one in auto-cameras and is growing its earnings in excess of 20 per cent. US regulation means that all new cars must have rear-parking cameras from 2017.”

Carmignac Emerging Discovery fund manager David Park also sees no shortage of opportunities for stockpickers but he asserts markets are still in a “fragile state” as a result of higher debt levels and lower profitability.

China’s steel industry, he points out, has 1.2bn tonnes of capacity but demand only for 700 tonnes, which is why much is being sold off cheaply abroad. “Demand is only growing at 4 per cent a year,” he says. “To reach capacity would take a long time.”

Like Palmer, Park seeks out under-penetrated industries because this brings “long-term secular growth”. One such holding is Shanghai International Airport, which he says is very much a play on rising Chinese tourism.

Elsewhere, he highlights the private banking sector in India, which only has a 25 per cent market share and as a result is primed to take business away from the troubled state-owned organisations.

JP Morgan Emerging Markets Income fund manager Omar Negyal, who has mostly avoided China, notes that there are rising opportunities for the yield hungry, given that the MSCI Emerging Market index now yields over 3 per cent. “Emerging market prices are reaching near crisis territory, a level at which long-term investors have historically been rewarded for investing,” he says.

Negyal points to Brazil, which has been under severe pressure but whose government has mandated companies pay out 25 per cent of earnings in the form of dividends to shareholders. Right now, notes Negyal, Latin American brewing giant AmBev offers a 5 per cent dividend yield with the prospect of continued growth.

Hermes head of investment office Eoin Murray bel-ieves that looking over a five-to-10 year horizon, on a broad basis he can see emerging equities offering between 2 and 3 per cent real yield pick-up over developed equities. One potential blot on the horizon, he notes, is that private sector credit as a percentage of GDP is running at high levels in several emerging countries, notably Thailand, South Africa, China, Malaysia and Vietnam.

He says: “Assuming that lending must slow relative to GDP, there may well be significant negative impacts on future growth. From a currency perspective, significant pain has already been inflicted versus the dollar – if China devalues, either in a jump or in more measured steps, will other emerging economies have to respond in kind to remain competitive?”

Funds being backed

Despite the problems surrounding developing markets there is no shortage of funds still being backed by advisers and fund pickers. An active approach seems to be the preferred strategy.

Connolly rates the Austin Forey-run JP Morgan Emerging Markets fund, which is overweight India but underweight China. Over the past five years the port-folio is down by 1 per cent, but is up 8 per cent in the past two. Connolly says: “While the fund has not performed well in recent times, it should continue to be a consistent longer-term performer in its sector.”

While Investment Quorum’s Lowman has recently added the Baring Emerging Markets fund to his preferred fund list, one of the CIO’s core plays in the sector has been the Somerset Emerging Markets Dividend Growth portfolio. The vehicle is a concentrated fund comprising typically some 40 stocks and has been managed by Edward Lam since its launch in March 2010. Some of his bigger country plays include South Korea and India and in the past five years the fund’s dividend bias has helped it deliver a 29 per cent return.

Tilney Bestinvest’s Hollands likes the Stewart Investors Asia Pacific Leaders portfolio, formerly First State Asia Pacific Leaders, which is up a hefty 50 per cent over five years. The fund is quite conservatively run, and while it has investments in India, South Korea and Hong Kong it also has exposure to developed markets such as Japan and Australia. However, Tulloch will hand over the reins of the fund to his deputy, David Gait, when he steps down later this year.

For an investment trust spin on his portfolio Hollands recommends the Pacific Assets Trust, also run by Gait. Like other Stewart Investors portfolios, it presently has a big overweight in India and is very lightly exposed to China. The portfolio is popular among investors, given it has achieved a 79 per cent return over the past five years and is on a discount of just 2.8 per cent.

Rathbones senior research analyst Mona Shah also believes investment trusts could be a way to play the emerging markets universe, given that discounts have generally widened so much. Within the sector she highlights Templeton Emerging Markets, which is off by 24 per cent over five years and on a deeper discount of 14 per cent. Managed by veteran Mark Mobius it has 20 per cent of its assets in China and Hong Kong, about 12 per cent in South Korea and 11 per cent in Brazil.

What about emerging market bonds?

While developing market equities have been dealing with their own spate of problems, the fledgling asset class that is emerging market debt has been attempting to win the minds of investors. Progress, however, has been slow.

Given the ubiquitous hunger for yield, EMD still remains under-owned by retail investors compared with other bond funds.

The Investment Association originally launched the Global Emerging Markets Bond sector on 31 December 2013. At the end of January 2014, the category housed £2.4bn in funds under management. Fast-forward two years and that total has dropped to £2bn.

But while enduring a rough period in the second half of 2015, the average fund has achieved a total return of 8 per cent between the start of 2014 to 23 March this year, just ahead of the 7 per cent achieved by the Sterling Strategic Bond sector average.

Ashmore head of research Jan Dehn believes that right now EMD offers a far better risk reward proposition than developed market bonds and that yields are high enough “to compensate for capital losses in a much shorter time”. He says: “On average, emerging market bonds make up for capital losses between six and eight times faster than developed market bonds.”

But Chelsea Financial Services managing director Darius McDermott cautions that EMD funds are ultimately suited to more intrepid investors, given the various risks that come with investing in them – most notably political instability and currency. For investors happy to shoulder the greater volatility he tips the Standard Life Investments Emerging Market Debt and Aberdeen Emerging Markets Bond funds.