Portfolio Adviser • October 2016 • Fund Selector

For those that can stomach the risk, emerging market performance is scaling new heights as the tailwinds of 2015 turn to headwinds

What a change in fortunes emerging market equities have experienced during 2016. After risk assets endured the worst start to the year since the Great Depression, 10 months on and emerging markets equities have comfortably outperformed their developed market counterparts in the year to date.

What has driven this reversal in performance? In short, there has been an aboutface in US interest rate speculation, the strength of the dollar, the trajectory of the Chinese economy and global energy and commodity prices.

In December 2015, the US Federal Reserve raised its base interest rate by 0.25% for the first time in a decade. The global markets had been dogged by speculation over when this might happen: employment data was strong, the labour market tight and there was marginal inflation.

Markets began to price in a future rate hike and the dollar strengthened. Both of these factors influenced investors’ decisions, and both are bad for emerging markets for two reasons.

First, emerging markets tend to be heavily reliant on foreign capital inflows to fund fiscal or current account deficits. A potential interest rate hike improves the prospect of higher investment returns in the US, causing capital to flow out of emerging markets.

Second, a stronger dollar poses a further threat to emerging market investment: local currency devaluations caused by a reversal in capital flows make servicing dollar debt more onerous for governments, corporations and banks.

Similar events and effects were first witnessed in May 2013 with the so-called ‘taper tantrum’, which effectively started a threeyear malaise for emerging market equities that ran until the start of the year.

The collapse in energy and commodity prices over 2015 weighed heavily on commodity export-led economies such as Brazil and Russia, both of which were not helped by internal and geopolitical issues.

Low energy prices, driven by the oil-producer group Opec’s bid to restrict the US shale phenomena, would ordinarily act as a fillip to emerging markets, as these regions are big energy consumers. However, there is an inverse relationship between the value of the dollar and oil and commodity prices. When the dollar strengthens, oil and commodity prices tend to weaken.

This scenario has been reversed in 2016. The oil price recovered from a low of about $25 per barrel, with the Brent Crude spot price almost doubling since then. Commodity prices also gathered momentum, providing a boost for emerging markets. For example, Brazil’s main index, which had been in the doldrums, delivered in excess of 30% in local currency terms this year.

Just as US monetary policy plays its part in dictating the fortunes of emerging markets, so too does the outlook for the world’s second-biggest economy, China. For several years there has been speculation that excess debt and industrial overcapacity would lead the Chinese economy to a hard landing. Such fears weighed heavily on all markets.

Then in August 2015, and again in January 2016, the Chinese devalued the renminbi. This led to a sharp correction in markets, with the new year devaluation causing wholesale investor panic and the suspension of the Chinese stockmarket twice in a week.

Beijing is trying to transform China’s economy from being investment led to consumption driven. Navigating this transition without causing a sharp decline in economic growth is tricky and will not happen over night. But the government has plenty of levers to pull and buttons to push in order to soften the country’s economic landing.

Talk of a hard landing seems to be dissipating as recent economic data, if it is to be relied on, has been more positive. Annualised GDP growth is 6.7%, and recent data for the ‘new economy’ and consumption goods related sectors are very positive.

For the time being, concerns about a Chinese economic slowdown and more transparent currency policy has increased risk appetite among investors, in turn boosting demand for emerging market equities.

The economic headwinds that emerging markets faced in 2015 seem to have become tailwinds in 2016. The consensus view that there would be at least four incremental US rate rises this year was unfounded. In turn, the dollar has weakened leading to a recovery in oil and commodity prices. Meanwhile, in the background China is getting its house in order.

Throw in events such as Brexit, which turned investor sentiment against developed markets, and emerging market equities have hit a purple patch. But is it sustainable?

There has been speculation that another taper tantrum is on the cards as markets once again focus on US monetary policy. While the Fed stayed its hand at its September meeting, the tone of the accompanying statement hardened and, with three dissenting votes, was far from unanimous.

All of which supports the consensus view that there will be at least one more hike before year end, most likely in December.

A US rate hike will likely lead to a stronger dollar, which in turn could restrict the capital flows into emerging markets. Commodity prices could come under pressure once more and China may be forced to make further currency decisions.

Whether the tailwinds turn back into headwinds remains to be seen. But regardless of the macro-economic influences there are still reasons why emerging markets still look favourable from a long-term perspective: structural reforms, corporate governance and valuations.

A number of emerging market countries are implementing structural reforms, with India and China making headlines.

Narendra Modi’s victory in India’s 2014 presidential election paved the way for meaningful reform in a once politically fractured country. For example, the approval of the Goods and Service Tax Bill, which removes intrastate tax barriers and should drive growth.

In China, reforms are taking shape to rebalance the economy, including a deep clean-up of low profit, high debt, mismanaged state-owned enterprises. These are two examples among many of how emerging markets are getting their houses in order.

Corporate governance, often criticised in emerging markets, is also improving. We have seen what kind of influence capital flows can have on emerging markets and many companies within the regions realise that better governed firms tend to attract more foreign capital.

The clear implication is that if an emerging market company wants to attract for eign capital, it needs to improve on its governance. This is why there is a growing dividend culture in emerging markets, as dividend-paying companies are generally more shareholder friendly.

Finally, and not least, we should be looking at valuations. Emerging market equity valuations have increased across the board year to date due to recent demand. However, they still look attractive versus their developed market counterparts.

On a simple price/earnings basis, the MSCI Emerging Markets Index is trading on 14.7x, while the MSCI World Index trades on 21.3x. Across the emerging markets universe, price/book valuations for most countries are at, or close to, the bottom of their respective ranges for the past decade.

Emerging markets play an increasingly important role in the global economy, given their demographics and economic growth prospects. Combined, these countries account for around 40% of global GDP, according to the IMF.

Investing in these markets does come with a high degree of risk. However, for those who can stomach that inherent risk, at these current valuation levels, emerging market equities remain attractive and could prove to be a good recovery opportunity for long-term investors looking to gain exposure at the current time.

‘THROW IN EVENTS SUCH AS BREXIT, WHICH TURNED INVESTOR SENTIMENT AGAINST DEVELOPED MARKETS, AND EMERGING MARKET EQUITIES HAVE HIT A PURPLE PATCH’

‘EMERGING MARKET EQUITIES REMAIN ATTRACTIVE AND COULD PROVE TO BE A GOOD RECOVERY OPPORTUNITY FOR LONG-TERM INVESTORS’

. Baillie Gifford has a strong presence in this area and the Baillie Gifford Emerging Markets Growth Fund provides exposure to mainstream large, liquid emerging market stocks. The team are bottom-up growth investors, taking a non-indexed, unconstrained approach. The fund managers place great emphasis on their ‘buy and hold’ long-term growth strategy, so expect short-term periods of relative underperformance.

. Hermes Global Emerging Markets Fund is managed by Gary Greenberg (pictured), a seasoned veteran of emerging market investing. His investment style focuses on high-quality names while keeping a key valuation discipline. The fund is not constrained in terms of the regions, sector or at an index level. It has outperformed its benchmark with lower volatility over most time periods and offers actively managed, core exposure to the sector.

. Templeton Emerging Markets Smaller Companies Fund is not for the fainthearted. As per investing in smaller companies, the rewards can be high but so are the risks. The fund management team is led by the highly regarded Mark Mobius, who has more than 30 years’ experience. The fund adopts Mobius’ value approach seeking smaller companies in the sector believed to be trading well below their intrinsic value.

. With several other multibillion pound passive funds already established in the sector, Fidelity’s addition to its index range of funds, Fidelity Index Emerging Markets, makes sense. After all, as long as it keeps a tight tracking error to the index and the costs are competitive, which they are at 0.23% OCF, then assets under management should grow accordingly.

L Credit to Legg Mason, which has kept on the management team of Legg Mason IF Martin Currie Emerging Markets Fund since acquiring Martin Currie in 2014. With a lot more resource and distribution at their fingertips, the team is in a far better position under the Legg Mason banner and so there is much greater potential for the fund to grow beyond its £17m in size. However, the management team has to keep its end of the bargain and maintain the strong performance achieved during the past year.

. Newton Global Emerging Markets Fund has been open for just over a year yet has attracted inflows of more than £75m, so the future looks bright. Newton has some pedigree in this area through institutional mandates, which they are hoping to replicate with this fund. The manager, Robert Marshall-Lee (pictured), is an exponent of Newton’s thematic investment process and he has produced some solid numbers since the fund’s inception.

. Aberdeen Emerging Market Equity Fund runs a successful fund within markets that can be illiquid. The fund was a ubiquitous holding in many higherrisk portfolios due to its long-term risk adjusted numbers. Pre-taper tantrum in 2013, the fund reached more than £4bn in size, which led to it being closed due to liquidity concerns. It remains shut but has now shrunk to about £1.5bn, with speculation that it might re-open.

. Since the advent of global quantitative easing, the hunt for yield has moved between and within asset classes. MI Somerset Emerging Markets Dividend Growth, run by Edward Lam (pictured), has been a distinct beneficiary of investor demand for income, which has seen the fund grow from £300m to more than £1bn in less than three years. Of course, yield is not enough in itself and the total return performance since its launch has been very strong.

. The popularity of Vanguard Emerging Markets Stock Index highlights the ongoing division between passive and active investors. Pro passive investors argue that most active managers fail to beat broad benchmark indices and levy high charges for failure. This fund provides you with index level returns but at a significantly lower cost (0.27% OCF) and is why the fund is around $7bn in size. Liquidity is not an issue due to the fund’s synthetic replication approach.