Are emerging market equities more attractive than EM bonds?

The asset class does appear to have recovered somewhat as the White House administration has floundered, stumbling from one crisis to another.

Meanwhile, emerging market equities are on a similar road to recovery, growing again after years of decline and finding favour once more among UK investors.

Should investors be favouring one asset class over the other in their portfolio?

It seems investors still need convincing of the case for allocating to emerging market equities, even though they represent good value when compared to developed market equities, where valuations are at near all-time highs. 

Despite the decent fund flows seen into the asset class so far during 2017, the legacy of a challenging four-year period for emerging markets prior to 2016 is that many investors remain under-allocated.Ross Teverson

Global emerging markets account for approximately 12 per cent of the MSCI World index and investors are around 4 per cent underweight, according to Dan Tubbs, head of the global emerging markets (GEM) equity research and portfolio management team at Mirabaud Asset Management.

He points out investors have not been this underweight in emerging market equities in about five years, although more recently flows into GEM equities have begun to improve.

He also dispels the myth investing in emerging market equities is simply a play on commodities.

“In fact, energy and material stocks account for only 7 per cent of the index each,” he notes. “The GEM universe is actually much more of a play on global technology as the largest sector in the MSCI Global Emerging Markets index is now technology, with a 25 per cent weighting.”

In spite of a pick-up in interest in emerging market equities this year, investors are still underexposed to the asset class.

Figure 1: MSCI Emerging Markets index daily performance over five years to 1 September 2017

Source: MSCI

Ross Teverson, head of strategy, emerging markets at Jupiter Asset Management, explains: “We see reasonable valuations (or attractive valuations if one compares emerging market equities with developed market equities) in combination with scope for positive earnings surprises as key tailwinds for emerging markets.  

“Also, despite the decent fund flows seen into the asset class so far during 2017, the legacy of a challenging four-year period for emerging markets prior to 2016 is that many investors remain under-allocated.”

Attracting flows

Mr Teverson suggests should emerging market companies continue to deliver solid earnings growth, it is likely more money will flow back into EM equities, and with many emerging market companies boasting strong balance sheets there is plenty of opportunity for improved shareholder returns.

He takes Samsung Electronics, the second largest constituent of the MSCI Emerging Markets index, as an example of a company with an attractive valuation, scope for further positive earnings surprise and a strong balance sheet. 

He notes the recent sentencing of Samsung heir JY Lee is of little consequence for the company’s strategic or operational direction.

“Given Samsung is the largest player in an increasingly oligopolistic global memory chip market, for which datacentres have become a major and growing source of demand, earnings upgrades are likely to continue. 

“What’s more, the company has net cash on its balance sheet equal to almost 20 per cent of its market capitalisation and has taken steps to improve shareholder returns via higher dividends and share buybacks,” Mr Teverson says.

While emerging market equities are trading at a 21 per cent discount to their developed market peers, according to Pavel Laberko, emerging markets equity manager at Union Bancaire Privée, he warns there are headwinds “in the form of potentially aggressive hawkish policy by the US Federal Reserve, while a global economic slowdown could deteriorate its progress”.

So far, the Fed has adjusted its interest rate policy broadly in line with market expectations, which has helped reactions in EM bond markets stay fairly muted.Claudia Calich

For Gary Greenberg, head of global emerging markets at Hermes Investment Management, emerging market equities are more attractive than emerging market bonds “as EM bond spreads are narrower than historical averages and equity valuations are close to average”.

“EM equities enjoy an improving global environment, calm political waters (unusually, and not in every case, of course), in an environment of modest valuations,” he reasons.

“EM debt is more closely affected by rising US rates (we think there is another 100 basis points to go before EM equities are affected), but in essence enjoys the same benign growth environment, plus have the added benefit of enjoying, for the most part, much more robust sovereign balance sheets than previously.”

Rate tightening path

Perhaps some of the investor caution around emerging market bonds has been the uncertainty around the Federal Reserve’s interest rate path.

It had been predicted the Fed would hike interest rates three times in 2017, and having raised the benchmark interest rate for the second time this year in June, to a range of 1 per cent to 1.25 per cent, many are predicting the third and final hike to come in December.

Claudia Calich, manager of the M&G Emerging Markets Bond fund, notes rising interest rates can be a headwind for emerging economies.

“So far, the Fed has adjusted its interest rate policy broadly in line with market expectations, which has helped reactions in EM bond markets stay fairly muted,” she says. 

“We believe the asset class should continue to withstand further gradual rate rises by the Fed, given the considerations of better fundamentals, improved current accounts and lower US dollar debt levels. However, sentiment towards the asset class could be more adversely affected if the central bank feels a faster pace of rate tightening is warranted.”

Ms Calich observes the asset class rallied strongly following the broad sell-off in the aftermath of the US election, while acknowledging investors were right to weigh up the potentially adverse implications for emerging market assets of a Donald Trump presidency.

From an income investing perspective, comparing earnings yield to bond yields shows that investors are being better rewarded for taking on equity risk in the short term.Wei Li

“Encouragingly, gains have been registered across the local and hard currency sovereign markets, as well as hard currency corporate credit, helped by factors such as strengthening global economic growth and reduced concerns about political risk in developed countries,” she adds.

She also forecasts the creditworthiness of emerging market bond issuers will stabilise as economic growth edges upwards.

Equities and bonds

Wei Li, head of EMEA investment strategy at iShares, is in agreement that overall, equities look more attractive than bonds, "as valuations look cheap relative to history and to EM bonds". 

“From an income investing perspective, comparing earnings yield to bond yields shows that investors are being better rewarded for taking on equity risk in the short term,” he adds. 

But over a longer time horizon, Mr Li suggests it makes sense to have exposure to both emerging market equities and bonds.

As does Mr Laberko of Union Bancaire Privée and his colleague Koon Chow, emerging markets fixed income strategist who believe: “When taking into account the strong momentum of both emerging market asset classes, it is shrewd to maintain exposure to both, subject to risk and other preferences, but were the respective headwinds to intensify, beware of the systemic risk with equities, and the specific risks with bonds.”

An allocation to both emerging market equities and emerging market bonds should help diversify a portfolio and iron out any volatility, while also capturing the recovery in both asset classes.

eleanor.duncan@ft.com