Ignore emerging markets at your portfolio's peril
The long-term case for emerging markets has been well-made - high growth rates, strong demographics, the development of vibrant consumer economies - but investors in emerging markets have had a difficult ride and may need their enthusiasm reinvigorated, particularly with the apparent slowing of a number of the major emerging economies.
Everyone's favourite investment in the run-up to the credit crisis, the stockmarkets of emerging economies have suffered relative to developed markets in its aftermath. The MSCI Emerging Market index is up 3.71% over the past three years, compared to a rise of 5.75% in the MSCI World index. Asian markets have been particularly weak, notably China, while Latin American and EMEA (Europe, Middle East and Africa) markets have supported the overall performance.
Much of this weakness has not been the fault of emerging markets, but rather that as investors hunkered down in the aftermath of the financial crisis, they sold off those areas of their portfolios they perceived as higher risk. Economic growth rates in emerging markets, in many cases, remained relatively robust. Brazil, for example, grew 7.5% in 2010, China by 10.4% in the same year.
But now there is a clear slowdown in some of the major emerging market economies. China has moved from annual growth of around 10%, to a level of 7-8%. Brazil has levelled out at between 2-3%. Part of this has been engineered: the governments of both countries tightened monetary policy to curb some of the exuberance, choke off excessive lending and rebalance the economies. However, both have been the engine of emerging market (and indeed global) growth, so the concern about slower growth rates has merit.
Richard Titherington, head of emerging markets at JP Morgan, says that the slowdown has been overplayed: "China is having a cyclical slowdown not a structural slowdown. It may have issues in the longer term - it needs to float fully its currency and open up its capital markets, it also has a demographic issue - but investors should not worry in the short-term."
He argues that the relative weakness of the stockmarkets in recent years and the current poor sentiment towards the asset class are enabling investors to buy at lower valuations. Stockmarkets are much more attractively priced than they were five years ago. Titherington says: "Whether emerging markets are a good investment is largely a function of the price investors pay. While it would seem logical that investors would be rushing to buy growth in the current environment as there is so little growth in developed markets, this has not happened.
"On a number of metrics, valuations for emerging markets are trading at near crisis levels. Yet at the same time, we believe that relative risk is as low as it has ever been."
Titherington believes the other key advantage for emerging markets in the current environment is diversification: "The eurozone crisis has demonstrated the risks of over-concentration. So-called 'Black Swan' events are more common. When I started investing in emerging markets, there were 200 companies trading more than $5 million (£3.1 million) per day and thus liquid enough for us to consider investing in them. Now there are 800, spread across 30 countries with very different economic cycles, and different characteristics. It spreads risk around much more broadly for investors."
The recent difficulties in developed markets have also narrowed the gap between emerging and developed markets, which means emerging markets no longer look substantially riskier. Titherington says: "Emerging market companies are starting to look much more like developed world companies in everything from balance sheet management to prioritising shareholder returns. For example, there is much greater emphasis on dividend payouts."
It is worth remembering that many of the traditional arguments for emerging markets still apply. Growth rates may have slowed in the BRIC economies, but there are still plenty of areas that could tempt investors as a long-term growth story.
Developing Asia is projected to grow at 7.9% in 2013, with China, India, Indonesia, Thailand and Vietnam all expected to grow by more than 6%. Russia and Latin America both have expected growth rates of 4.1% for 2013. This is significant when compared to developed markets - the US has the highest projected growth rate of 2.3%, while the euro area is likely to grow at just 0.3%, the UK at 1%.
However, after the experience of the last few years, investors would be forgiven for not wanting to put their life savings into the asset class. Emerging markets will always be volatile, however strong the long-term growth story. A regular savings plan can mitigate some of that volatility. As the tables below show, lump-sum investment may give a higher return - as has been seen over the past three years - but investors have to be lucky with their timing.
Equally, as the asset class matures, there are plenty of alternative approaches to emerging markets: for those with a higher risk appetite, or a longer time horizon, single country emerging market funds can offer a means to 'super-charge' a portfolio; while those with a lower risk tolerance may look to emerging market income funds, or even emerging market debt funds.
Emerging markets have come a long way and are no longer just an investment in global growth, or the commodities cycle.
Market analysis, where appropriate, provided by J.P Morgan Asset Management.
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