Right side of history

Political uncertainty and currency volatility have been flashpoints for emerging markets this year. Sell-offs initially triggered by concerns about economic stability and the outlook for growth have been prolonged by geopolitical events. That volatility is likely to continue given that countries holding uncertain elections amount to 28 per cent of total emerging market gross domestic product.

Investors have to put today’s market nerves into historical context. Unlike the 1990s, today we have floating currencies in many more emerging markets and hold much larger foreign exchange reserves. Having floating rather than fixed rate currencies acts like a pressure valve on emerging markets – it means that tension gets released on a daily basis and in reaction and alignment to the world’s major currencies. This may mean sharper daily volatility, but it creates continual rebalancing instead of perpetuating a broken system.

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Despite significant short-term headwinds for the asset class, the long-term structural dynamics for many emerging market economies remain intact. Urbanisation ratios in India and China are dramatically below US and Japan, which should lead to higher levels of income and consumption, supporting market returns.

Also, volatility has weighed on emerging market equity performance, resulting in cheaper valuations. When price-to-book values have fallen below 1.5x, the MSCI Emerging Markets Index has historically registered double-digit returns over the following 12 months. Given emerging markets are approaching their lowest levels in over five years, history suggests that investors can expect reasonable returns looking ahead, especially relative to developed market equities.

Investors focused on long-term fundamentals will find this presents an attractive entry point. There are always unforeseen risks in emerging markets and it is an asset class driven more by sentiment and confidence than others. After the strong performance of developed market equities in 2013, emerging market equities currently trade at the largest discount to developed market equities in nearly 10 years.

It is important to remember investments are made in companies and not countries, hence the enormous differentiation among emerging markets and the need for an active approach to separate winners from losers. It is a big mistake to take a blanket approach to emerging markets and tar them all with the same brush. We are talking about a part of the world that represents 80 per cent of the world’s population and 50 per cent of it is GDP, so of course there are huge variations, geographically, culturally and economically. Some areas have been punished on a price basis simply by virtue of their locations, whereas others carry significantly more risk, so you have to be selective.

The difference in total returns in MSCI country performance over the last 12 months has spanned more than 50 per cent, highlighting the importance of a selective investment strategy.

Some further investment considerations about emerging markets include: