The US central bank’s financial stimulus that began in late 2008 sent a flood of capital into the developing world. The cost of this policy is now being counted by businesses and investors alike. Brazilian oil producer Petrobras, for instance, is under serious financial strain after building $104bn in net debt, the highest of any energy sector company. Patrick Cadell, global fund manager at Liontrust Asset Management, says: “Debt has been a big worry for investors in emerging market equities.”Jerome Booth, chairman of New Sparta Asset Management, agrees there are “very high levels of debt in countries in the developed world”. But he argues Western policymakers are using stresses in the Chinese economy as a “bogeyman”, because they prefer not to believe there is anything amiss with developed countries. Yet the ratio of public debt to GDP in the US is 100 per cent and 132 per cent in Italy, according to Bloomberg data. In India and Indonesia, public sector indebtedness is much lower, at 50 per cent and 27 per cent respectively.
The big short
“Shorting” emerging market equities — or betting the valuations of these stocks will fall — is one of the most “crowded” trades in the world, as identified by a survey of fund managers by Bank of America Merrill Lynch.
However, voices of dissent are building. Against a backdrop of uncertainty about the US economy and the health of eurozone banks, global asset managers “pared back” their “extreme underweight positions” in emerging markets in February, the survey noted. That means they are at least less pessimistic than they were a few weeks ago. So more buying is occurring than it was.
Could now be the time for individual investors to follow suit? Investors should recognise that emerging markets have had a habit of rebounding and then disappointing at various points during the past five years. Data from Capital Economics show that short periods of outperformance, when the ratio between the MSCI Emerging Markets index and (developed) world indices rose, have often been followed by longer periods of underperformance.
Dennis at UBS cautions that forecasts of price/earnings ratios can appear low on emerging economies’ stock markets because analysts’ earnings expectations for EM companies are often too high. He says it is common for earnings growth forecasts across the 23 emerging markets he tracks to start the year very optimistically before trending lower. Six months ago, for example, analysts forecasted 13 per cent earnings growth across companies in this asset class for 2016. Two months into the year, that forecast has fallen to 4.7 per cent, according to UBS data. Gave of Gavekal, says that even if emerging markets are oversold, investors should avoid the countries and companies that are most reliant on commodities — from oil to copper to iron ore — for their wealth. Net exporters of commodities, according to the United Nations Conference on Trade and Development, include Russia, most countries in South and Central America and South Africa.
Brent Crude oil, which rose to more than $100 a barrel in June 2014, slumped to a long-term low of just £28.62 in January, due to global oversupply and weak world trade. Oil companies are pumping out 1m more barrels a day of the black stuff than the world needs, according to Reuters data.
A bout of mine building by commodities companies, beginning during China’s boom years, has contributed to an oversupply of metals that some analysts believe could persist for years.
“I see no reason to invest in commodities producing nations for the next 30 years,” says Gave. “Commodities cycles often do last a generation. You have a bust, no one invests, you have a shortage, prices zoom for the next three or four years, everyone invests, you get overcapacity, then you get 30 years of stagnation.”
How to buy
When it comes to emerging markets, a problem for retail investors is how to identify investments they want to make. If you have not visited a country and do not know the local language, it is difficult to form a view. Liontrust’s Cadell has invested 10 per cent of his fund in Indonesia, where rock-bottom oil prices have allowed popular new president Joko Widodo to patch up the country’s finances by ending a costly commitment to subsidise fuel prices. The nation has a strong reputation for corruption and for disappointing foreign investors, however, so should probably be left to expert fund managers.
Gave takes a broader view, recommending that investors stick to “the countries that are transforming commodities [and] are benefiting from low prices”. China is one such country, as is South Korea, although the doubts around the health of Chinese banks and financial system should be a strong consideration here.
A broad-based emerging markets fund may be a prudent buy. Listed investment trusts that own EM stocks and are trading below the book value of their assets could be worth considering. JPMorgan’s Emerging Markets Investment Trust, for example, was priced at a 13 per cent discount to net assets at the time of writing.
When choosing managed funds, investors should carefully scrutinise the manager’s fees and costs, which can greatly reduce the value of one’s savings over time if too high. There are also a number of low-cost exchange traded funds that track the MSCI Emerging Markets Index. This index is currently dominated by companies that transform commodities instead of producing them, and are mostly based in Asia.
As Dennis’s “eureka” moment in 2002 demonstrates, however, it is always hard to time an investment in emerging markets. Those choosing to invest now will be surrounded by doubters. But if investors wait until everyone thinks the time is right, the price could be too high.
Could emerging market valuations get any cheaper? Probably. But if you want to own them as part of a well-balanced portfolio, then this is a gamble some investors may be prepared to take.
So what is an emerging market?
There are many classifications of emerging markets, although a favourite benchmark for investors is the group of countries listed by index provider MSCI. These include: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates. Other classifications are broader, and may include countries considered more “frontier”, such as Nigeria, or even rich states such as Singapore. It is often argued that South Korea is too wealthy a nation to be in the MSCI Index, but removing it would greatly change the weighting and valuation of this index. Its first or second largest member by market capitalisation is usually South Korean smartphone and semiconductor maker Samsung Electronics, which at the time of writing comprised approximately 3 per cent of the index.
(concluded)
Naomi Rovnick
