Will this emerging markets rally last?

After a rocky few years, the Association of Investment Companies' global emerging markets sector has picked up in 2016, with an increase of 31% over the year to the end of August, compared to the average fund's 9% increase.

When sterling fell after the Brexit vote, those who invested in emerging markets received a boost. But is the emerging markets rally sustainable?

The sector has always been a tumultuous one: while it has outperformed the wider industry average by 23 percentage points over 10 years, it has underperformed by 52 percentage points over five years. It is usually seen as an area for more sophisticated and higher-risk investors.

However, it remains to be seen whether the current rally proves to be sustainable in the long run. So what is the outlook for the sector?

Improving investor confidence

Speaking at an Association of Investment Companies event on emerging markets prospects, Carlos Hardenberg, manager of Templeton Emerging Markets Investment Trust, says: "Over the past few months emerging markets have continued to outperform developed markets as investor confidence has improved.

"That said, investors generally have a much lower weighting to this asset class in their portfolios. We believe that investors' underweight position, attractive valuations and the search for higher-yielding assets could continue to support long-term performance in emerging markets."

Companies in emerging markets are moving up the technology learning curve very fastHe pointed out that most flows into emerging markets have been through exchange-traded funds (ETFs), and that the MSCI World Index might be 'overweight' in China, which remains a risky region.

He stays away from government-related companies in countries such as China and Russia, because they are too risky and inefficient, and buys private companies instead.

Hardenberg finds opportunities in small and mid-cap companies in emerging markets. He argues that a number of good companies in the technology sector "are very cheap as they have been punished for the wrong reasons".

"Companies in emerging markets are moving up the technology learning curve very fast, whether it is in Fintech and digital banking or more innovative manufacturing and many other areas.

"We are also interested in the frontier market space, which offers a strongly growing middle class and some very good companies at valuations we haven't seen in a long time."

Emerging market comeback

Omar Negyal, manager of JPMorgan Global Emerging Markets Income Trust, says: "There has been a material uptick in the outlook for emerging markets this year, as we've seen currency stabilisation and emerging market economic growth starting to feed through.

"This has resulted in early glimmers of evidence that emerging market earnings are on the verge of making a comeback."

The sector is still at risk from developments in China and the US presidential electionCommenting on where he sees investment opportunities, he says: "We like a number of semi-conductor companies in Taiwan, for example, which offer high returns on capital. Taiwan has a robust dividend culture where companies often pay out over half their earnings as dividends."

"Apart from adding into weakness, into positions in Brazil and South Africa late last year - to capitalise on attractive dividend yields and fundamentals - we have made no dramatic changes to the portfolio over the past year, which is benefiting from improving sentiment towards emerging markets as well as improving fundamentals.

"We have increased our underweight to China, as in general we see better dividend opportunities elsewhere."

Nonetheless, on the whole the emerging markets sector is still at risk from both developments in China and the looming US presidential election.

This article was originally published by our sister magazine Money Observer here

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.