EM stocks see strong returns but vulnerability still exist

Only hindsight will reveal the true answer, but for what it’s worth emerging market equities do look like one of the better options at present. 

As always, there is plenty of noise to contend with. Emerging markets have been through several cycles over the past three decades, and these phases are the baselines that underscore day-to-day fluctuations of financial markets. In the good times, optimism turns to euphoria, leading to poor investment decisions and lofty valuations. This is the point of maximum financial risk. 

The ensuing collapse inspires reform and improvement, but not before the price, and therefore valuation, has dropped through the floor. This is the point of maximum financial opportunity.

Emerging markets fitted the bill for the latter as 2017 began, and we positioned accordingly. Sentiment was certainly very poor, with dollar bulls suggesting a rising greenback would heap yet more misery in their direction. 

Valuations, meanwhile, looked attractive, particularly relative to US equities, about which investors seem particularly sanguine. And sure enough, with the help of devalued currencies and a decent bout of reforms, emerging market corporate earnings stopped falling and, in many cases, have begun growing modestly again.

Is this a new phase? It would be foolish to declare that for sure until after the event. Positions in these markets should be held with the recognition that perfect timing of any turn would be highly unlikely. Much as they can be happy with returns so far, investors must be prepared for the possibility these returns are not the turn of the cycle, but instead are just a staging point on the way to the truly darkest hour.

We have been taking some profits as the fourth quarter approaches, but overall we are retaining decent-sized exposures. This is based on valuation, and not on a guess about the economic or political future. Emerging markets still look reasonably attractive, although clearly less so than a year back.

We are relatively positive about the potential to make good returns over the next seven to 10 years, albeit with a few notable bumps along the way. In relative terms, the picture looks even better, and investors scrambling about in bonds or US equities looking for any stray pieces of good value may wish to consider emerging markets.

Risks should not be ignored though. Emerging markets may look reasonable value in aggregate, but like any market they contain pockets of vulnerability. One area that may prove sticky in the future are the Asian technology giants. 

Asian indices, and the emerging market indices they dominate, have been driven higher by stellar returns from the likes of Tencent and Alibaba, echoing the Fang-driven US market. The reason for the excitement is understandable, and may well prove justified in time, but previous experience with highly valued stocks like these still creates unease.

There are also macro risks to consider, and concerns over credit growth in China and the unpredictability of North Korea have the potential to reverse the gains seen this year in short order. 

As such, this may be a basket to put some of your eggs in, but by no means all of them.

Simon Evan-Cook is a multi-asset fund manager at Premier Asset Management

KEY FIGURES

£335m

Net inflows into the IA Global Emerging Markets sector in 2017

80%

Rise in Tencent’s share price this year

27%

MSCI Emerging Markets index’s exposure to technology stocks