The long game

Kerry Craig

This year emerging equity market performance has been the ugly sister to developed markets’ Cinderella.

The MSCI emerging markets index is down 5.5 per cent year to date through to the end of August, while the developed market index is up nearly 13 per cent (price return basis only). The possibility that the Federal Reserve will taper its bond buying scheme has exacerbated the situation and emerging market currencies and equity markets have suffered. Investors are understandably, but perhaps undeservedly, questioning the investment potential of these markets.

Emerging economies have faced several headwinds so far this year. Lower global demand for commodities and a strengthening dollar have hurt economies such as Brazil and Russia which are reliant on commodity exports to generate revenue. China is undergoing a policy-induced slowdown as it looks to re-engineer its economy to a consumption-driven model. Emerging economies are also battling higher inflation after years of relatively strong growth – and now they face the problem of rising wages which are eating into corporate profitability.

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Money flew into emerging markets when central banks pledged to keep interest rates low and investors from the US and other developed markets sought better returns elsewhere. Now that it is more than likely that the Fed will announce tapering this month, money has been flowing the other way, causing emerging market currencies to weaken. It was not so long ago that countries such as Brazil were complaining that their currencies were too strong and governments began talking about a currency war. Now the opposite is true.

The currencies of countries with larger current account deficits have been affected the most, as these countries are heavily reliant on external financing to fund growth. The central banks in Indonesia and Brazil have increased interest rates to prevent further currency devaluations at a time when economic growth is slowing and monetary policy should be getting looser, not tighter. Investors may be worried that the downturn in emerging markets will become a full-blown crisis, reminiscent of the 1997 Asian financial crisis. But many countries have learnt the lesson of that episode, building up significant currency reserves and no longer needing to protect pegged exchange rates.

Investing in emerging markets is about playing the long game, on the basis that the pace of growth in emerging economies will vastly outstrip that of the developed world in the long term, even though it may be slower than in recent years. Many of the issues affecting emerging economies today are cyclical in nature and do not detract from the long-term growth story. The fundamentals of long-term investment and consumption, as well as a younger demographic profile, remain in place and should mean longer-term emerging market outperformance. The backdrop of negative news and falling prices for emerging markets has therefore created an opportunity for investors, with emerging market valuations looking attractive both in the context of their own history and relative to developed markets. The MSCI EM index is trading at a price-to-book ratio of 1.5x, while the MSCI USA index is at 2.5x.