11 Nov 2018

Emerging Markets – Beauty Or The Beast?

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Normally around this time of year my unfortunate wife has to listen to me explore with her some analysis of where we should invest our few pension shillings for the year ahead.   This year when I raised the potential of emerging markets she looked at me quite jadedly and promptly replied, “Well if you think this is the year they’re going to emerge then it sounds like a great idea.” English grads will always have a quip for you!

 

‘Emerging market’ is a term that investors use to describe a developing country, in which investment would be expected to achieve higher returns but be accompanied by greater risk.

 

The original emerging market flagship was the MSCI index which started in 1988 and had only 10 countries in it and amounted to only 1% of the world equity markets. Thirty years on the index now has 24 markets represented and it has grown considerably to 10% of world market capitalisation.   The mix of countries in the index has developed considerably over time, China which wasn’t represented at all in the original 10 now counts for 31% of the index while India and Brazil make up 8% and 6% respectively.

When you at look at the graph below you may well indeed wonder why I would even consider such an investment.   Throughout 2016 and 2017 the trend was that emerging markets could do no wrong, however since the start of this year the index is down c11.2%.  Chinese equities in particular have fallen significantly with the Shanghai composite index losing almost 20% this year. The reasons suggested for the fall are that the rising interest rates in the US and the trade tensions between America and China have lead to investors reducing their capital in emerging market holdings. In addition, selected currencies have come under pressure such as those of Argentina and Turkey due to their debt holdings in US Dollars.

The rising Dollar has had a twofold effect leading to the maelstrom conditions for emerging markets this year. One is that US government bond yields go up so investors see less of a need to move into perceived riskier assets such as emerging market equities.  Secondly a stronger dollar makes has an economic impact on companies as it increases the value of their Dollar denominated debt and the servicing of it.

So when we look at the future of emerging markets do they have more pain to come or are they possibly offering good value at present?

The potential that the increasing US interest rate cycle will continue through 2019 would imply that there is more pain to come, particularly for those with US Dollar debt.  The opportunistic view might be that emerging market equity valuations are close to multi year lows.  In comparison to the US market they are at a 40% discount on a price/ earnings basis which is the largest gap since 2002.

Rising trade tensions and their impact on manufacturing capital expenditure has been a key concern, driving the 20% share price decline year to date across all sectors with consumer sentiment weakness beginning to impact GDP.  Moreover, no one is really sure how the US – China trade disagreement will play out although Chinas exports to the US are relatively small.  The recent rhetoric had died down between them ahead of the US mid-term elections but this may pick up again before the G20 summit in November.

Volatility is a key factor to be considered when investing in emerging markets. The graph below very clearly shows how differing market conditions create much larger swings leading to steeper troughs and peaks compared to developed market indices over time.  This is most clearly seen in the plunge of 2008, the summer of 2011, the spring of 2016 and all of 2018.

What is interesting to note is that in the 15 year graph below recovery times are similar to the more established world indices. The falls may be steeper and more severe but the time required to recovery is quite similar.

For fear of repeating myself this type of investing is not for the faint-hearted. For those who wish to partake, the 10% global equities is probably a good indicator in terms of a suitable portfolio proportion. A five to ten year view would be quit important with this one.

Source: MSCI Emerging Markets (www.msci.com)

 

Source: MSCI Emerging Markets (www.msci.com)