GlobalApr 3 2017

Pessimism over EMs may be unwarranted

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Pessimism over EMs may be unwarranted
With relatively low valuations, the case for investing in selected emerging market shares remains compelling

By the end of 2015 emerging market (EM) shares had meaningfully underperformed developed market (DM) shares over five years and were one of the most disliked asset classes.

It was a low point: a survey of global fund managers by Bank of America Merrill Lynch found that managers’ preference for DMs over EMs was the highest in the study’s 15-year history. That sentiment translated into investment flows and EMs were disproportionately on the losing end, leaving them available at a substantial valuation discount to DMs. 

EM performance rebounded in 2016 and those same fund manager surveys now find investor sentiment to be relatively neutral. While that’s an improvement from the previous year, it’s still overly pessimistic. EMs remain attractive on broad valuation metrics, with the MSCI EM index trading at 1.5 times book value compared with 2 times for the MSCI World index, despite the fact that both indices have produced a similar return on equity.  

A good performance and a compelling valuation case normally leave sentiment upbeat, but there are two fears that continue to deter investors from investing in EMs. 

 The correlation between EM relative returns and changes in US interest rates has been low, both during normal market conditions and in periods where US interest rates have risen steeply

The first is the belief that the sector underperforms when US interest rates rise, coupled with the view that rates are unsustainably low. The second worry stems from the conviction that EMs underperform during bear markets, coupled with the view that equity markets are high and thus the probability of a bear market is above average.  

However, both of these beliefs are not supported by history and clinging to them may cause investors to miss out on what may be an attractive long-term investment opportunity in EMs. 

Since the 2008 financial crisis, authorities in the US, as well as Europe and Japan, have kept interest rates near zero in an effort to stimulate economic activity and have used quantitative easing to spur looser lending. Such an abundance of ‘cheap money’ is arguably unprecedented, and it’s understandable that investors worry about what happens when/if monetary policy tightens. 

The view that EMs should underperform if US interest rates rise comes partly from the idea that EMs are speculative: such investments typically suffer most when interest rates rise and borrowing becomes more expensive. Conversely, when capital is cheap, as it has been in recent years, speculative investments should benefit as investors chase higher yield and turn to ‘riskier’ investments.

Pessimists about EMs also reason that higher interest rates generally cause the US dollar to strengthen; this increases the burden on developing countries with significant dollar-denominated debt and creates the potential for havoc in their financial markets. Even if this were true, today’s pessimism may be unwarranted. EMs are generally on a stronger financial footing than in the past, having heeded the call following the 1998 Asian financial crisis to build foreign exchange reserves. Additionally, a greater number of them have adopted flexible currency regimes, which help make countries more resilient to external shocks.

However, an examination of EM relative performance since 1987 – the start date for the MSCI EM Index – suggests this has not been the case. The correlation between EM relative returns and changes in US interest rates has been low, both during normal market conditions and, more importantly, in periods where US interest rates have risen steeply, which has happened four times in the available history. 

If this dogma were true, then investors may be right to fear for EMs, as DM valuations appear generally elevated and a turn in the cycle could be painful. However, there is little evidence to support this claim.

There have been five major DM bear markets since 1900 and, with only one exception, EMs either outperformed DMs or have fared evenly. The only time that EMs underperformed during a DM bear market was 2009, and they went into that downturn with premium valuations following five years of outperformance – quite a different backdrop to today. 

Therefore, an examination of the data suggests history is not on the side of investors who believe EMs are speculative investments prone to always underperform in a DM bear market. As the main reasons cited for avoiding EMs don’t seem to withstand scrutiny, investors should treat EM investing in the same way they would treat any other asset class: by focusing on fundamentals and valuations. By these measures – with valuations relatively low and profitability solid – the case for investing in selected EM shares remains compelling. 

Dan Brocklebank is head of Orbis Investments UK