Investing in emerging markets has been a bumpy ride for the past several years. Some investors may be considering whether they should avoid these markets altogether because of their recent underperformance versus developed markets. However, we believe there are plenty of good reasons for staying invested in emerging markets over the long term.
When we look at emerging markets, we focus on the underlying fundamentals of the investment. We consider both the broader macro economy and the corporate environment within our assessment. In our view, current conditions suggest potential improvements for emerging markets.
Devan Kaloo, Head of Global Emerging Markets, Equities, took on the role of a conjuror performing a magic trick with a couple of props, in a striking
presentation to the investment conference. He gave a lesson to longterm investors in the importance of choosing the right time frame, with a pair of graphs that abruptly vaulted his audience from a pessimistic to an optimistic perspective on emerging market performance.
Mr. Kaloo acknowledged frankly that “over the past five years emerging markets have significantly underperformed developed markets – by something like 60%.”
However, he mentioned, “if you’ve been stuck in emerging markets for ten years, you’ve seen outperformance of about 40%.” Looking at markets on a long-term basis, he suggested that this decade-long period might be “the right time frame.”
He also pointed out that emerging markets underperformed developed markets by 8% in 2014 with a negative absolute return of 2% in U.S. dollars. But this still made emerging markets the second best performing asset class, doing better than Japan, Europe or the UK. While if you calculated returns in Euros, Yen or Sterling you made a positive absolute return.
In short perspective is important.
Mr. Kaloo used his presentation to outline the potentially brighter future for emerging markets, with improvements in macroeconomic and corporate conditions likely to pay off in better stock market returns.
Core to his argument for a long-term assessment was the notion that temporary travails in emerging equities did not reflect fundamentals. “People quite often take the view that stock market performance in the short term reflects underlying issues in that market,” he said. However, “in emerging markets that clearly is not the case.”
This disconnect existed, Mr. Kaloo said, because emerging stock markets are often led by foreign investors. “Domestic institutional and retail investors are not consistent players in the market, so the guys who drive emerging markets are typically foreigners”, he explained. “This is important, because foreigners sometimes get concerned about different things from what’s actually occurring on the ground.” For example, “what’s happening with quantitative easing, and the impact of the European Central Bank (ECB) and Bank of Japan, can have a large impact on liquidity flows into emerging markets, and a disproportionate impact on the performance of these markets.”
Moreover, because emerging stock markets are, in most cases, less liquid, it did not take much to send them up or down. “To put it in some sort of context, over the past three out of four years they’ve seen negative outflows,” he noted. “So there’s been a lot of money going out of emerging markets.” Or has there? Adding some clarity, Mr. Kaloo stated “Actually it’s not a lot of money. For 2014 we’re talking about $25bn. That’s a rounding error on the Federal Reserve’s balance sheet.”
“Although $25bn is not a huge amount of money in global macroeconomic terms, the illiquidity of emerging markets – largely because so much of the market capitalization is made up of shares that were not free-floating – meant that “it doesn’t take an awful lot of money to swing these markets around.”
Mr. Kaloo argued that if investors ignored short-term negative sentiment that had nothing to do with emerging market companies themselves, they could be rewarded by improving fundamentals.
He acknowledged that worries about U.S. monetary tightening had hit emerging equities, by stoking fears that emerging economies’ current account deficits, hitherto financed by the large global supply of dollars, would no longer be sustainable. However, Mr. Kaloo also pointed out that, by raising interest rates, emerging economies had reined in these deficits. For example, India’s central bank predicts that the country’s deficit will shrink to 1.3% of gross domestic product this fiscal year, down from a record high of 4.8% in 2012-13.1 He calculated that the reduction in deficits left emerging markets much less vulnerable to further signs of U.S. monetary tightening.
He highlighted that he believes the sharp decline in the price of oil is also largely a beneficiary for emerging markets, with almost 75% of emerging economies net oil importers. The potential benefits include improved fiscal position via reduced oil subsidies; narrowing current account deficits as oil
import bill comes down; falling inflation which should lead ultimately to lower interest rates; and accelerating economic growth as a result.
He also ventured the idea that emerging market companies had responded well to tough times: “They’re cutting costs, and doing the right things. That will eventually lead to better profitability.” Given the large discount these companies trade at relative to the recent past and to regional peers, things don’t look too bad.
In a talk that repeatedly addressed the investment conference’s theme – “Perspectives on Time” – Mr. Kaloo confessed light-heartedly that his son had come up with the title for his presentation, “Emerging Markets – are we there yet?”: “We were stuck in the car, and he said ‘are we there yet?’ about fifty times. That’s what it feels like with emerging markets over the last couple of years.” His conclusion: “Stay in the car, enjoy the journey. Things are getting better. In ten years’ time we believe you’ll have made more money than you have now.”
1 Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks.These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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