Investment Comment: Emerging markets: A risky bargain

Despite cheap valuations, investors must exercise extreme caution

EMERGING market equities have underperformed developed markets for three years in a row. This year has been particularly volatile for the former, with concerns over the deceleration of the Chinese economy and the growing realisation that a wind-down in quantitative easing (QE) by the US Federal Reserve could have dire consequences for emerging markets.

These markets have recently benefited from the supply of cheap credit, but expectations of an eventual strengthening of the dollar have sucked capital back into the developed world. Debt levels in these countries have expanded significantly in recent years, and current account surpluses have deteriorated from around 5 per cent of GDP in 2006 to 1 per cent. As currencies have been hit, the cost of borrowing has escalated, exposing structural weaknesses.

Since the Fed surprised the markets last month by holding off its taper, there has been a relief rally across a number of emerging markets. With stocks now trading at a price-to-book ratio of 1.5 times and an average price-to-earnings ratio of 10 times, these markets look tantalisingly cheap relative to the major developed markets. It has prompted some financial advisers to hail a once in a lifetime buying opportunity.

Yet despite optically cheap valuations and their compelling long-term growth characteristics, investors must exercise extreme caution. The recent bounce back in emerging equities could be short-lived.

In the near term, the looming deadline on raising the US debt ceiling will dominate market concerns. Yet so far stock markets have been relatively sanguine, perhaps overconfident that a deal will be done. A US default would have far reaching consequences for the global economy, which could trigger panic across risk assets, including placing renewed pressure on emerging markets.

But even assuming America’s warring political factions pull back from the brink, market attention will soon recalibrate to estimating when tapering will commence, reigniting a process of the re-pricing of risk which partially fuelled the emerging market sell-off during the summer.

Given the potential for further turmoil in emerging markets, investors who are tempted to invest should take care not to throw caution to the wind, and consider drip feeding money in to the markets over a series of months.

We favour funds with strong risk management approaches, which avoid companies with weak or inefficient balance sheets and the most illiquid shares. One of our top choices is the Lazard Emerging Markets fund, which has beaten its bench mark over one, three, five and 10 years.

However, bargain hunters should also look the investment trust sector, where the JP Morgan Emerging Markets Investment Trust is trading at an 8.7 per cent discount to net asset value. Another good choice for investors with an eye for potential downside risk is the Asian Total Return Investment Company – a former Henderson investment trust – which is now in the capable hands of Robin Parbook and Lee King Fuei of Schroders.

Under the management of the Schroders team, the Asian Total Return Investment Company has adopted a new strategy, which seeks to limit downside risk through uses of derivatives. It is an approach that has been used with considerable success on other funds managed by the team, and could prove valuable should a further wave of volatility hit emerging markets.

Nonetheless, we remain cautious on emerging markets, notwithstanding the fact that they now look cheap.

Jason Hollands is a managing director at Bestinvest.