Asset allocators are split over whether investors will make a sweeping return to emerging markets (EMs) in the coming months after it proved the best performing equity market in the first quarter.
Despite much of the talk coming into this year being focused on value versus growth, Europe and the continuing strength of the US market, the MSCI Emerging Markets index notched up a 9 per cent return year-to-date.
This was higher than global stocks, US, UK and European indices and also EM’s best performing quarter in more than five years. Sentiment, reflected by performance, appears to have turned positive after a slump following Donald Trump’s election.
However, while some investors have backed EM, UK asset allocators have been reluctant. Debate has ensued over whether last quarter’s performance was enough to change minds.
JPMorgan Asset Management global market strategist David Stubbs said: “The big sentiment holding back EM is people thinking we’ll get a strong dollar. Today’s emerging markets are not that vulnerable.
“[Q1] should be the proof that they need. In the aftermath of the US election, fears over emerging markets were widely overblown. The collection of macro indicators since then should be negative for EM, but they keep outperforming.”
Fund sales for EM equities remain relatively weak. Investment Association data for the first two months of 2017 showed net outflows of £7m and no meaningful net sales since the US election. This compares with £130m into US equity funds and £72m into Japan in January and February. Equity sales generally in 2017 have been relatively weak, however.
City Asset Management investment manager James Regan said he expected investors to remain nervous about removing EM underweights.
He claimed the opportunity cost of not investing in the region was not high enough for clients to withstand the volatility, given first-quarter equity returns had been strong in most markets.
The MSCI Emerging Markets’ 9 per cent return was against 5.5 per cent from the S&P 500, 6.6 per cent in FTSE Europe ex-UK and 5.1 per cent for the MSCI World, in base currency terms. “Investors are hesitant to deal with the volatility. You can turn on the news and EM might have fallen 10 per cent,” he said.
Many would remain more comfortable in US, UK and developed markets, Mr Regan added, and the spread between returns would need to grow before flows turned.
Mr Stubbs, a self-proclaimed EM bull, added that unreasonable fears of a reliance on commodities and links to the dollar strength and US monetary policy still kept investors at bay despite the rising market.
On this basis, Mr Stubbs said the macro environment in the first quarter should have been negative for EM, given expectations for dollar strength, a rise in the interest rates and comments last week from the Federal Reserve over unwinding its quantitative easing programme.
Other economic data somewhat supported Mr Stubbs’ case. Capital Economics noted a “sharp turnaround” in EM growth in recent months with many of the largest economies set to “surprise on the upside”.
This was due to improving data and commodity prices proving less of a headwind, lack of policy from Mr Trump and Fed tightening not affecting the regions as before. Capital Economics said flow directions were turning.
“Fed tightening has not caused major problems for EMs. Our capital flows tracker suggests that outflows from emerging markets have actually eased in recent months,” Capital Economics noted.
Mr Stubbs added: “A lot of the investor community don’t understand how to play emerging markets and will continue to seek reassurance about [them], probably as they miss a large chunk of returns.”
