Growing pains

There has been much discussion of a ‘mass investor exodus’ out of emerging markets, but just how significant have outflows been in the context of the overall asset base? The global mutual fund and ETF emerging markets flow data (see table) suggests, “not very”. Selling may continue, but outflows from dedicated emerging market equity and bond funds, estimated at about $28bn (£16.4bn) year-to-date, are little more than a rounding error in terms of total market size.

We should remember that emerging market assets have increasingly become a strategic allocation for pension funds and other institutional investors around the world. While recent gyrations serve as a useful reminder that emerging markets are volatile, it is doubtful that many institutional investors will be reducing their strategic allocations to these regions. If anything, after several years of relative underperformance, we expect many of these investors to rebalance their portfolios, perhaps resulting in flows back into emerging market assets throughout the year. ‘Hot money’ flows may make headlines, but the activities of strategic investors are more important over the long term.

Figure 1: Global mutual fund and ETF emerging markets flows

That emerging markets have become an increasingly important part of the global economy is undeniable. According to the IMF, 2013 was the year in which emerging and developing economies overtook developed ones in terms of contribution to global economic output. This is remarkable given their collective share of the pie was only about 37 per cent in 2000. In equity market capitalisation terms, emerging markets have more than doubled from 5 per cent in 2000 to about 11 per cent at present. Additionally, there is little doubt that emerging market debt has become more accessible over the same period, with almost $700bn (£412bn) in dedicated funds and mandates. This means that emerging markets are currently too significant an opportunity for investors to ignore.

Although they have recovered a little recently, emerging market bonds and equities have struggled since May 2013, when Ben Bernanke announced that the US Federal Reserve would look to taper its regular bond purchase programme should the economy continue to improve. However, it was not just emerging markets that suffered. A range of assets sold off as they became relatively less attractive, suggesting that tapering does not explain the whole story behind recent emerging market under performance.

Emerging market equities have underperformed developed market equities in two of the last three years, cumulatively returning about 45 per cent less. In short, the underlying issues that have contributed to the emerging markets slowdown are not all driven by interest rates in the US. This suggests that rising rates in the US do not necessarily mean that emerging markets assets need to suffer.

If the economies adjust – a process that has already begun – and companies deliver, there is no reason why emerging market assets cannot perform well in a rising rate environment as happened between 2003 and 2006. Some argue it is all about US monetary policy, but company and country-specific fundamentals matter too.

There is no doubt that some emerging market economies face significant structural headwinds and ongoing market volatility has the potential to cause further issues for certain countries. Those with large current account deficits, such as the so called ‘fragile five’ – Brazil, India, Indonesia, South Africa and Turkey – are perhaps the most vulnerable to changes in investor sentiment. In broad terms, though, emerging markets are in rude health today.

With the exception of a few notable outliers, fiscal characteristics are also generally favourable, particularly in comparison to developed market countries. Therefore, it seems a little premature to write off countries that collectively generate more than half of the world’s economic output. After all, the developed world also faces long-term challenges, be that funding the retirements of ageing populations or reducing structurally high levels of unemployment. As the table illustrating key characteristics of major emerging markets suggests, there is much to like about where they are today.

So, are emerging market equities the great value opportunity of the moment? Or are they the classic value trap, an asset class that is stressed out with risks to the downside?

Buying stocks on valuation alone can be a risky business. Generally, investors like to look for a catalyst that will contribute to making a cheap stock or asset a good long-term investment. After all, some assets are cheap for a reason. At times, emerging markets have traded at a premium to developed markets, while today, they trade at a discount, with the gap widening over the last several years. This indicates potential for attractive investment opportunities.

However, markets show that there are considerable variations from a valuation perspective and disparities between countries highlight that perhaps emerging markets, like their developed markets counterparts, should not always be considered in one broad sweep.

As a measure of corporate profitability, Return on Equity can be subject to manipulation (for example, through a management adding excessive leverage), but it can also be a useful gauge of how successful companies have been historically.

ROEs of emerging market corporations have been declining since mid-2011, generally not a positive for stock market performance, but we have seen a similar dynamic for UK and eurozone companies even as their equity markets have rallied strongly. This suggests investors are more optimistic that their issues are temporary in nature and that future profitability will improve, while issues with emerging market companies are viewed as more structural and likely to take longer to turn around. Any signs that ROEs are beginning to bottom out could act as a catalyst for emerging markets stocks, which investors should be aware of.

Moving away from a focus on companies, interest rates in emerging markets have risen much more steeply than rates in the US, UK and Europe. This is driving yields on the local currency government bond market back to levels not seen since early 2010. Yields on hard currency government bonds are also significantly higher than recent lows, with the spread relative to US treasuries back up to over 400 basis points. In a world where developed market interest rates are still at or near historic lows, these high yields must surely be attractive for investors looking for diversified sources of income.

Finally, while GDP growth does not always equate to strong stock market performance, sometimes, as the GDP growth chart suggests, it makes sense to take the long-term view.

Matthew Arnold is senior ETF strategist of State Street Global Advisors

Key Points

Emerging market equities have underperformed developed market equities in two of the last three years, and the trend looks set to continue

Inspite of the challenges facing emerging markets, it seems a premature to write off countries that collectively generate more than half of the world’s economic output.

High interest rates in emerging markets which are driving high yields on the local currency government bond markets should attract investors.