Is it a mistake to dismiss emerging markets?

The surge of capital rushing out of emerging markets has risen to $1trn (£650bn) over the past year but investors may be too quick to dismiss the sector.

Total net capital outflows from the 19 largest emerging market economies reached $940.2bn in the 13 months to the end of July, which was almost double the $480bn that exited the region during three quarters of the financial crisis, according to data from NN Investment Partners, which was previously called ING Investment Management.

This week alone, following the worsening market data coming from China, there were $10.5bn of outflows from the emerging market sector – the largest since January 2008 – according to a Bank of America Merrill Lynch Global Research report. 

Axa Wealth head of investment Adrian Lowcock says emerging markets are “hugely out of favour” at the moment following a period where the market was attractive and became overvalued relative to developed market peers.

He says: “As the West recovered from the financial crisis, emerging markets’ better economic growth rates did not translate into improved earnings sentiment.

“In addition, a strengthening recovery in the US and a stronger dollar have made some emerging markets less attractive to invest in. Many companies had borrowed in US dollars at low rates, which worked while the currency was weak and interest rates are at a record low, but starts to get expensive when the tide changes.”

Many global emerging market funds have experienced large outflows in the past three months, with Aberdeen’s Emerging Markets Equity fund topping the list. The £1.68bn fund, which Lowcock believes to be likely to suffer purely because of its size, has seen approximately £123m in net outflows during the period, according to FE data.

This was followed by the £690m Schroder Widows Emerging Markets fund, which lost £53m in net flows over the period.

Other funds seeing mass withdrawls in the sector include the £856m Scottish Widows Emerging Markets fund, which lost £25m, as well as the £158m Newton Emerging Income fund, with around £24m in outflows. 

Undoubtedly, the recent Chinese market fall has spread worries around the whole emerging market sector contributing to investors’ decreasing appetite.

NN Investment Partners senior emerging markets strategist in the multi-asset team Maarten-Jan Bakkum adds that chances for improvements are very low in the short term and capital outflows will continue to be driven by the Chinese market’s crisis.

He says: “Outflows will continue and will also accelerate. It has been very bad in the last weeks for emerging markets and I will not count too much on it.”

Lowcock adds: “China compounds these matters and dominates the sector these days. The country is still undergoing a transition from exporter to domestic consumer and is making mistakes along the way. Economic data tends to be cyclical and often picks up towards the end of the year.

“As such emerging markets currently out of favour could see a rebound in the short term if China’s economic outlook improves. However, it maybe a while longer before they truly come in from out of the cold.”

However, other experts think investors should not lose sight of the emerging market sector as it will not take too much to move the sentiment dial.

Orbis Investment Advisory director Ben Preston, whose flagship Global Equity fund is overweight emerging markets relative to the MSCI World Index, says investors could be missing many “compelling opportunities” if they decide to join the queue of those shedding the sector.

He says: “Dismissing a whole region out of hand is a mistake. Economic conditions in many emerging markets have clearly deteriorated, but long-term investors should not be deterred. Investing during times of economic weakness often yields the best long-term results.”

Though a number of emerging market funds have seen high outflows recently, other funds in the space have in fact experienced abundant inflows during the past three months.

The £890m Fidelity Emerging Markets fund topped the list, attracting around £75.3m, while the £554m L&G Global Emerging Markets Index fund collected more than £74.7m new assets, FE data finds.

Investors do not appear to be chasing immediate returns, as the £1.45bn M&G Global Emerging Markets fund, which collected over £43m in the period, saw worse performance the Aberdeen Emerging Market Equity fund. M&G saw a loss of £220m in the three months thanks to poor performance, compared with Aberdeen’s £178m loss.

Though sentiment towards Asia remains negative “signs of capitulation” are generally the best buying opportunities in Asia on a medium-term view, says Andrew Swan, BlackRock’s head of Asian equities for the fundamental equity division of BlackRock’s Alpha Strategies group.

He says: “When Asia has traded in the valuation range of 0.9 to 1.4 times book value, according to Citigroup data, then the probability of a positive return on a 12-month and 36-month view is greater than 80 per cent.

“The widespread dispersion in market performance within the region also offers an attractive playground for bottom-up active investors to take advantage.”

Preston also warns western assets may not be “as safe as many think”.

He says: “A business is not inherently a safe investment just because it operates in the US or Europe. Risk has many components. It may well be less risky to own a high-quality and well-financed company in a developing country, than a mediocre or heavily indebted company here or in the US.”

However, Bakkum predicts the “diversion” of investments from emerging markets to developed markets will increase over time.

He says: “Investors are much more aware of the situation now [in emerging markets]. They are increasing their cash pots as well as investing in developed market equities, although these have been weak in the past weeks.”

FE EM outflows