Emerging markets lag frontier nations

The sector’s continued outperformance of emerging markets (EMs) was helped by superior growth, continued inflows from international investors and the promotion of two of the major constituents in the index to EM status – United Arab Emirates and Qatar.

Geopolitics was an ever-present issue, particularly in the Middle East, while several countries devalued their currencies, including Argentina, Kazakhstan, Ghana, Nigeria and Vietnam.

The underperformance of cyclical sectors was a common theme across both EMs and frontier markets, with mining and energy stocks moving to multi-year lows – a result of weak demand and falling commodity prices.

The sudden collapse in the price of oil served to focus investor attention on the beneficiaries of such a decline, with Asian markets the clear winners and Russia, the Middle East and Nigeria among the most obvious losers.

EMs have underperformed developed markets by an unprecedented 53.3 per cent across the past five years. This extends a frustrating period for investors in EMs with the index essentially range-bound, while developed markets have delivered solid gains.

The issues that hindered EMs included continued earnings disappointments, lacklustre GDP growth, expectations of early US Federal Reserve monetary tightening, widespread weakness in EM currencies against the US dollar, continued selling pressure from foreign investors and deteriorating sovereign (Russia, Brazil) or corporate governance (South Korea).

Those markets that outperformed did so following positive political change (India, Indonesia and Thailand) or in anticipation of market reform (China).

The question many investors are asking is whether the good times will continue for frontier markets. Returns during the next year are likely to be driven by a small number of key considerations.

In the short term, investor attention will remain focused on the path of energy prices. It seems reasonable to assume that these will remain volatile and prudent to assume that they may stay lower for longer as strong, sustainable growth still eludes many parts of the world.

In such a scenario, the recent beneficiaries will continue to benefit while exporters suffer.

The poor performance of EMs in 2014 was exacerbated by currency losses. Many EM and frontier market currencies now stand at levels only previously seen in times of crisis.

Recent weakness clearly reflects expectations surrounding the future path of US monetary policy, which still seems far from certain. Taken in aggregate, EM currencies are at their lowest level in 15 years. This belies the improved balance sheets and flexibility that the sector enjoys now relative to where it was 15-20 years ago.

A relief rally in EM and frontier market currencies is a distinct possibility if the benefits of greater currency competitiveness start to show in fundamentals or if expectations surrounding the upward path of US interest rates are delayed.

China will continue to take centre stage in the global economy this year. In spite of slower growth now being a reality, it is noticeable that some of the pessimism that surrounded the Chinese economy has dissipated over the past year.

The government’s reform agenda and continued opening up of the market to foreigners may continue to drive returns in specific parts of the market. The People’s Bank of China has already surprised the market with its November rate cut, and further stimulus measures appear likely given the economic slowdown.

Events in a number of markets in 2014 reminded investors of the importance of assessing geopolitical risks.

The Crimean/Ukrainian issue has reignited differences between the European Union (EU)/US on one side and Russia on the other. As a consequence of this standoff, the relationship between the West and Russia has reached levels of tension not seen since the end of the Cold War. This has resulted in falling asset prices in Russia and eastern Europe.

In the Middle East, the unexpected strengthening of Isis grabbed headlines. While the world was focusing on pushing back al-Qaeda, Isis was quietly growing stronger militarily.

Containing the spread of Isis and the de-escalation of the Ukrainian/Crimean issue could affect returns positively in the coming year.

Andrew Lister is co-chief investment officer at Advance Emerging Capital

KEY NUMBERS: EM INVESTMENT TRUSTS

15

The combined number of investment trusts that sit in the Association of Investment Companies (AIC) European Emerging Markets, Global Emerging Markets Equities, Country Specialists Latin America and Latin America sectors

6

Number of EM and frontier market trusts with a 10-year track record in the four AIC sectors

12.55%

Twelve-month return of the 15 best-performing EM or frontier market trusts to January 15 2015