Interactive Investor

Emerging market shares too cheap to ignore

19th May 2016 08:50

Kyle Caldwell from interactive investor

Emerging markets have been on a miserable run of form over the past five years, weighed down by collapsing commodity prices and slowing economic growth. Political scandals, most notably in Brazil and Turkey, have added to negative sentiment.

But in recent months emerging markets have started to return to favour, in turn giving funds that specialise in these regions a much-needed boost.

According to data from FE Trustnet, the average fund in the Investment Association global emerging market sector is up 13% over the three months to 10 May.

Overseas investors are piling in. According to French bank Société Générale, March saw the largest purchase of Asia assets - $15 billion (£10.5 billion) - by foreigners since July 2014, when they bought $21 billion. The majority of the money, 75%, was invested in equities.

Historic lows

Signs that the tide is beginning to turn come at a time when valuations are near historic lows.

On the basis of the price-to-book ratio shown in the chart (below right), the MSCI Emerging Markets index has only been cheaper on three occasions over the past two decades: in 1998, shortly after Asia's financial crisis; 2001, following the 9/11 terror attack, and late 2008 during the global financial crisis.

Tom Becket, chief investment officer at Psigma, is in the camp maintaining that emerging markets have become too cheap to ignore.

The trouble is that investors have heard this all before.

Shares were similarly cheap a year ago, and those who bought then are likely to be nursing sizeable paper losses, with the average emerging market fund down 11% year-on-year. Over five years the average fund has lost 10%.

This begs the question: why should investors return to the asset class now? According to Becket, the outlook has become more positive.

Positive outlook

"We appear to have seen something of a floor in a number of key commodities, most notably iron, copper and oil, all now showing a decent bounce from the lows," he says.

"Arguably the biggest change has been in China, which has seen a marked improvement in economic conditions in the past few months."

Another tailwind is the fact that the prospect of interest rates normalising in the US now looks less likely to happen anytime soon. Higher rates make emerging market dollar-denominated debt more expensive.

Some fund managers are more cautious, however. Gary Greenberg, manager of the Hermes Global Emerging Market fund, is concerned about the consequences of the removal of quantitative easing on the asset class.

Emily Whiting, an emerging market client portfolio manager at JPMorgan Asset Management, adds that the prospect of the US dollar strengthening is a significant headwind to emerging markets.

Over the long term, for the asset class's prospects to improve, at least one of two things need to happen, Whiting says.

"Emerging market GDP growth expectations need to improve, or developed market growth expectations need to fall further. The ultimate catalyst, however, for a sustainable recovery in emerging market equities will be an earnings pick-up."

Getting exposure

Investors considering a return to emerging markets could consider one of our sister magazine Money Observer's Rated Funds.

Of the nine contenders, the strongest performer over five years is BlackRock Frontiers, which won the Money Observer Best Emerging Market Trust award this year.

It has delivered a share price return of 37%. The trust benefited from manager Sam Vecht's decision in late 2014 to cut back sharply on exposure to Nigeria and Saudi Arabia.

Another Rated Fund worth looking at is Utilico Emerging Markets trust, up 27% over five years. It invests predominantly in listed companies involved in infrastructure, transport and similar sectors operating in emerging markets.

Manager Charles Jillings says: "Valuations are as attractive as at any time in the last 10 years, and currencies have been so weak that at some stage there must be a recovery."

The trust was highly commended in the 2016 Money Observer Best Emerging Market Trust category.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.