At the beginning of the year, things looked dismal for emerging markets. Investor optimism had soured over the previous three to four years, thanks to a cocktail of tumbling commodity prices, a strong dollar and a Chinese slowdown which had shaken confidence in the sustainability of their growth.
Nine months later, and the mood has shifted markedly, with capital pouring into both equity and bond markets in developing economies. So far this year, the MSCI Emerging Markets (EM) Index has risen by 14.4 per cent, compared with an increase of just 3.5 per cent on the World Index. And in July alone, global bond funds increased their emerging market debt allocation by an average of 16.5 per cent, according to figures by Morningstar.
What explains this resurgence? Quite simply, many of the trends which had fuelled investors’ pessimism have reversed, or at least halted.
A degree of stability
With low and negative interest rates predominating in developed economies, and trillions of dollars invested in bonds with negative yields, it is not hard to see the attractiveness of emerging market equities. “A yield of 6 to 8 per cent is rare on an asset class with a BBB investment grade quality, such as [you can get from] emerging market local-currency debt,” says Francesc Balcells, emerging markets portfolio manager at Pimco.
After three years of capital outflows, a degree of stabilisation has been enough to tempt investors back. Moody’s recently announced that it expects growth in the G20 emerging economies to stabilise overall, anticipating GDP increases of 4.4 per cent this year and 5 per cent in 2017. Its forecasts for growth in Russia, Brazil and China were revised upwards, while South Africa and Turkey were expected to slow.
“Emerging markets are still challenging from a growth perspective, but the depths of the recessions in the likes of Russia and Brazil are behind them, and balance of payments are improving,” says Balcells.
Currency strengthening has played an important role in luring investors back. “A number of key emerging market currencies like the Brazilian real, Russian rouble and Indonesian rupiah have been weak over the last three to five years,” says Ross Teverson, head of global emerging markets at Jupiter Asset Management. “Currency stabilisation this year has eased inflationary pressure, allowing for more stable monetary policy.”
Commodity prices, on which many emerging markets are dependent, have also settled, and aggregate current account deficits in China for example, have turned into surpluses as exports pick up, easing foreign investors’ fears.
In any case, a degree of volatility is a small price to pay when company valuations are so cheap. In February, the MSCI EM Index was trading at a 1.3 times price-to-book ratio, with emerging market stocks appraised at little more than the value of their assets.
Teveson says that investors tend to look at emerging markets and see a dichotomy between crowded, quality stocks and those which are cheap for a reason. “But in the mid-cap space, there are individual examples of companies with compelling, medium to long-term change playing out,” he says, citing the US-listed Hollysys, a Chinese industrial automation company, as an example.
Fear the Fed
But would a Fed hike spook investors? The exodus from emerging markets in 2013, known as the “Taper Tantrum”, was triggered by suggestions that the Fed would wind down its bond purchases, and raise interest rates, which would increase repayments on the dollar debt which emerging market companies had binged on since the financial crisis.
At last week’s Jackson Hole symposium, Fed chair Janet Yellen said that the “case for interest rate increases has strengthened in recent months”, signalling that another interest rate hike will take place before the end of the year. Worse still, the Bank for International Settlements warned earlier this month that emerging markets face $340bn in repayments over the next three years – 40 per cent more than the previous three. With higher interest rates, refinancing may be difficult.
However, Teveson is sanguine. “Moves by the Fed are a source of short-term volatility, but they won’t fundamentally change the earnings outlook for a lot of the companies we invest in. If you look at where valuations are today, you are paying an attractive price for a very strong medium to long-term outlook.”