Rates risk, tantrums, China slowdown: why buy Asia at all?

The precipitous sell-off in equity markets across the world which followed has come to be known as the ‘taper tantrum’.

But while developed market equities were hit hard, Asian and emerging market equities and bonds suffered far worse. The MSCI Emerging Markets index fell by 15.5 per cent between May 21 2013 and June 25 2013. Emerging market bonds did not fare much better.

The reason was that investors viewed that Asian and emerging markets had benefitted even more than developed markets from QE and other loose monetary policies from the US and the UK. The withdrawal of these policies was seen as a huge negative for these markets.

Ayesha Akbar, portfolio manager on the Fidelity Solutions fund of funds team, explains: “Emerging markets have been big beneficiaries of low rates in developed markets, as investors move further up the risk spectrum in search of yield. This led to large capital flows into many developing countries.”

With both the US and the UK set to raise their base interest rate in 2015, the question on investors’ lips is whether this monetary tightening will have the same sort of effect as the ‘taper tantrum’.

Another tantrum?

In the past month, equity markets have sold off sharply, with Asian and emerging markets suffering the worst. Some commentators have pointed the finger to investors focusing on a rise in US rates.

Ms Akbar says that the recent sell-off “may have been triggered by statements from the Fed that indicated they could hike rates by the middle of next year”, and the poor performance in emerging markets has “raised fears of a repeat of last year’s ‘taper tantrum’”.

In a recent paper on the state of the Indian markets following the election of prime minister Narendra Modi, BlackRock’s Ewen Cameron Watt, chief investment strategist of the BlackRock Investment Institute, cited persistent risks, including another “bloodbath” sell-off across the region.

“Risks remain and include a re-run of the 2013 bloodbath in emerging markets in anticipation (or fear) of a US rate rise because, while India is in better shape these days, the country is still dependent on external funding.”

But while commentators are warning of the risks of a US rate rise, such an event has been anticipated by the markets for several months and believers in the efficient markets theory would assume that it has been incorporated into the price of markets by now.

Emerging market equities are certainly at a cheaper level overall than developed market equities. The MSCI Emerging Markets index has a current forward price-to-earnings ratio (p/e) of 10.9x, while the S&P 500 has a forward p/e of 16.4x.

Such a disparity in p/e ratios has come about thanks to a significant divergence in performance between Eastern and Western markets in the past few years, which has led Asian equities to now look cheap on a relative basis.

Invest interest

This value has already begun to draw in investors. The recent data on fund flows from the IMA has shown a substantial pick-up in money flowing into funds in the IMA Global Emerging Markets sector and the IMA Asia Pacific excluding Japan sector.

And a recent global fund manager survey from Bank of America Merrill Lynch in August found that the number of managers buying into emerging markets had hit an 18-month high.

According to Robert Horrocks, chief investment officer at emerging markets boutique asset manager, Matthews Asia, this improved sentiment in terms of fund flows has not yet been particularly affected by the recent sell-off that he terms a “knee-jerk reaction to the idea of monetary tightening”.

Mr Horrocks says that sentiment and interest from clients in his firm’s funds, which was very low at the start of the year, has picked up through the summer and has not yet let up.

And he insists that a rise in US and UK interest rates should not have a massive impact on Asian markets. Instead, he sees Asian markets continuing to rally in the medium term, which he puts particularly down to an improvement in the earnings growth from companies in the region.

An improving outlook on the company level is also drawing in bottom-up stock-picker managers on global equity funds. Jeremy Lang, who co-manages the Ardevora Global Equity fund, says his current review of the global equity universe has thrown up a number of interesting opportunities in emerging markets. Particularly Asian markets such as China.

Mr Lang has had a negative stance towards the region for most of the life of the Global Equity fund, which was launched in 2010, but he says that he is now likely to start upping his weighting.

Headwinds

But while some companies may be emerging from the gloom in Asia, there are still macro economic headwinds aside from rate rises that remain. Chief among those is China.

Recent data from the powerhouse of emerging markets has disappointed the markets, showing a slowdown in the growth of industrial production and the property market. This has, in turn, caused some commodity prices to tumble.

The price of iron ore has plummeted so far this year. Many Asian markets are net exporters of commodities, so price weakness in this sector, if it persists, will cause problems for the region. Australia is particularly badly exposed to fluctuations in commodities as it makes up a substantial portion of its economy.

However, Joanne Warner, head of global resources at First State Investments, says that the mining sector should be classified as being “close to the bottom of the cycle”. She says demand for commodities “remains quite robust”, in spite of the issues in China, and that the main problem was an increase in supply.

However, new supply is likely to be “curtailed” by the low commodity prices so the commodities sector, and with it the many emerging markets that depend on the sector, could soon be on an upward trend again.

While a US rate rise, the slowdown in Chinese growth and commodity price weakness are all weighing on Asian equities, these are all stories well-known by the market and, at low valuations and with signs of earnings growth, it is likely that the current environment is not a bad time for a long-term investor to consider putting money into the region.

Matthew Jeynes is deputy news editor at Investment Adviser

matthew.jeynes@ft.com