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Why emerging markets could be a haven from potential shocks
Strong growth foundations are rebuilding BRIC allure
Follow the money: it's a phrase that applies not only to investigative pursuits but also to investing. So is the 'smart money' suggesting that private investors should be tilting their portfolios towards emerging markets?
Last month, I suggested that on relative valuation grounds, emerging markets were attractive, and I highlighted a trio of Money Observer Rated Funds making the running in Asia, emerging Europe and the wider emerging markets universe.
Institutional investors are sniffing out bargains too. More than $90 billion has been ploughed into emerging market equity funds this year, according to funds monitor EPFR Global.
Private equity inflows into emerging markets, too, are at their highest since comparable records began in 2008. The Emerging Markets Private Equity Association states that $22 billion (£16 billion) was ploughed into the asset class in the first half of the year.
Back in the realm of publicly owned equities, the forward price/earnings (PE) ratio for the MSCI Emerging Markets index is at a comforting 25-30% discount to developed markets. On 10-year cyclically adjusted price/earnings (CAPE) ratio, emerging markets stand at 16.1 times, compared with a historical average of 24.2.
The macroeconomic backdrop is also supportive: the International Monetary Fund predicts GDP growth of 4.5%, versus 2% for developed markets in 2017.
Recent purchasing manager index (PMI) levels across global emerging markets also suggest a bright future - all major regions bar Russia reported expanding manufacturing activity in August, cementing the trend of the past year.
As consultancy Capital Economics states, the aggregate emerging markets PMI reading of 51.7 in August (a reading of more than 50 signals expansion) is at a four-year high.
The prices of industrial metals have rebounded strongly, reflecting increasing demand for copper in particular.
At a forward three-month delivery price of $6,903 a tonne, the price of copper is at its highest for three years, and it's up a spectacular 20% since the start of June.
This is boosting the performance of commodity funds linked to emerging market fortunes, such as BlackRock World Mining (BRWM), which gained 21% in the year to 7 September.
Local currency strength has also boosted emerging market returns when converted back into sterling.
This has been a boon not only for equities but for bonds. Local currency emerging market debt funds have been among he best-performing asset classes in 2017.
The JPMorgan Emerging Markets Government Bond index was up 13% in the year to the end of August. US investment house GMO reckons emerging market currencies are still undervalued by historical standards.
When monetary policy in the US tightens, emerging market assets are historically among the first to feel the shocks.
So equity and bond investors alike will be reassured by Federal Reserve chair Janet Yellen's recent remark that the scaling back of its bloated balance sheet "will be like watching paint dry".
Less downside risk
It is fascinating that some professional asset allocators now view emerging markets as a haven from potential shocks in overvalued developed markets, which have been propelled higher by quantitative easing and the explosive growth of index trackers.
David Jane, head of Miton's multi-asset fund range, is among them. Jane is concerned that the downside risk in developed markets has become elevated, and that an unexpected event will "materially change sentiment" and send the "model-driven process into reverse".
He says: "We have been seeking areas where we can invest for exposure to equity returns, but at more reasonable valuations and with less downside risk should the process reverse. One such area is emerging markets."
While many investors are sensibly worried about the sabre-rattling in the Korean peninsular, no-one can say whether this will crash developed market stocks. But there are lessons from history, as Jane points out.
He says: "A classic would be the Russian crisis that led to the demise of the highly leveraged hedge fund LTCM. The parallels are clear: there are currently many highly leveraged funds, many of which are driven by models. We haven't yet seen an event lead to a sustained spike in volatility or a reduction in risk appetite. When that event occurs, we don't want to be too exposed to the assets that have become most overvalued in the model-driven buying spree. But in the meantime, we want exposure to the strong macro environment for equity markets. This leads us to consider the markets least driven by those factors [leverage, model-driven strategies and excessive valuations]."
In the year to date, and particularly over the past three months, many of Money Observer's Rated Funds in the Asia and emerging market asset groups have been among the best of our 198-strong crop for 2017.
Emerging market valuations, both relative and absolute, suggest that strong performance can be maintained.
Away from equities, more risk-averse investors should not ignore other emerging market assets, particularly infrastructure for its potential to deliver stable returns.
Data provider Preqin shows that funds focusing on emerging market infrastructure doubled in value between 2007 and 2016. That's not bad for a 'safe' asset class.
Jerome Booth, chairman of emerging market specialist New Sparta Asset Management, suggests that investors prefer developed market infrastructure because of "simplistic ideas about risk" and ingrained prejudice against emerging markets.
In a letter to the Financial Times, he says: "In a world still at risk of financial crisis in the west and distorted by quantitative easing, a repeat global financial crisis is a distinct possibility.
This could lead to developed and currently liquid markets suddenly becoming highly correlated, illiquid and big losers." Emerging market infrastructure should be seen as a refuge in such a scenario.
One of the few ways for private investors to get exposure to emerging market infrastructure is via Rated Fund Utilico Emerging Markets (UEM), a Money Observer favourite.
This investment trust focuses on underdeveloped and developed markets in Asia, Latin America, emerging Europe and Africa.
Utilico's growing dividend is paid quarterly, and its shares currently yield 3%. It returned 13.3% in the year to 5 September and 30.3% over three years.
Another possibility is Aberdeen Global Emerging Markets Infrastructure Equity, a Luxembourg-registered open-ended fund that returned 18% over the past year.
Emerging markets will not be immune to a bout of global jitters, but they are likely to bounce back faster and further than their overvalued developed market cousins.
Emerging markets ethical investing is finally coming of age
Investors should pay closer attention to funds and trusts that invest with environmental, social and governance (ESG) principles in mind.
In recent years they have, by and large, beaten those that do not. This is particularly true in emerging markets, where the MSCI Emerging Markets ESG Leaders index has performed significantly better than the widely followed MSCI Emerging Markets index.
The MSCI's ESG indices were launched in 2013. MSCI has back-tested the performance of its Emerging Markets ESG Leaders index to September 2007.
In the 10-year period the index returned more than 74%, while the underlying MSCI Emerging Markets index was up just 18%.
On an annualised basis over five years, ESG has returned 8.9%, compared with 5.7% from plain vanilla emerging market index exposure. Over 10 years, the annualised figures are even more favourable for the ESG index: 5.7% against 1.7%.
The above chart shows how favourably MSCI's global and Asian emerging markets ESG indices (converted to sterling) compare since September 2013.
Although ESG strategies are not uniformly comparable from one investment management firm or pension fund to another, they are gradually gaining widespread recognition for delivering superior and less volatile returns.
Institutional investors are taking note of this. Global reinsurer Swiss Re, for example, recently announced it will benchmark its entire $130 billion (£98 billion) portfolio against ESG indices.
A number of funds adhere to ESG principles in Asia and the wider emerging markets, including several of our Rated Funds. These include Hermes Global Emerging Markets and its sister fund Asia ex Japan Equity, and Stewart Investors' Asia Pacific Leaders fund and its sister investment trust Pacific Assets (PAC). Stewart Investors' Global Emerging Markets Leaders and Sustainability funds are also worth considering.
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.
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