James Jackson
We believe that emerging market equities should be a strategic part of client portfolios and are best expressed via unconstrained active investment managers.
We feel that the strategic thesis for emerging markets remains largely in-tact, with on-the-whole positive demographics, rising numbers of urban consumers and strong growth. Last year, emerging market equities were the standout asset class. However, year to date performance has been disappointing. We believe there are two main narratives as to what is the ultimate cause of this underperformance of emerging market equities. One is China’s vulnerability to the US-China trade war. The other is emerging markets’ vulnerability to a stronger US dollar/higher US interest rate environment.
Sentiment is also being undermined by bad news stories emanating from Turkey and Argentina. However, the former is a tiny part of the MSCI Emerging Markets index (just 0.5%) and the latter is not part of it at all. Even if the situation was to deteriorate much further, the direct impact would be small.
Our base case is that emerging markets will recover some of the lost ground and, therefore, we think investors who are at or below benchmark should use the recent weakness as an opportunity to build-up to modest overweight positions.
Sluggish emerging market performance is often associated with US dollar strength and the recent underperformance has been no different. Recent negative news-flow on emerging markets is more of an emerging market debt issue than an emerging market equity one.
Equities are a different asset class to emerging market government debt, with much higher exposures to China, South Korea and Taiwan. These countries are less vulnerable to tighter dollar liquidity which has impacted other emerging markets.
We believe that trade skirmishes are likely to be with us for at least another two years. Although this will be a headwind for emerging markets, we think markets are not pricing the breakdown in international co-operation consistently. Developed markets are under-reacting and some emerging markets, China in particular, are overreacting.
We think that the Chinese equity market may be over-estimating the sensitivity of listed Chinese companies to the problem as listed companies actually have little in the way of US sales.
US sales for MSCI China constituents average just 2.2% of total sales compared to 20% for MSCI Europe. As the local Chinese A-share market liberalises and the ‘partial inclusion factor’ (an adjustment made to the market capitalisation when deciding the weighting in the index) on A-shares is increased, China’s share in the index will increase further and, therefore, is likely to be a larger driver of return.
We think emerging market equities are now close to the bottom in relative performance terms versus developed markets. Whilst there is the potential for more downside, from either a big escalation of trade tensions, more pessimism about the global economic cycle or another surge in the US dollar, we think these risks are now largely priced in and further falls would represent an overshoot of fair value.
Whilst idiosyncratic risks remain, with certain countries such as Turkey creating concerns, we think that (with the exception of Asia) it is difficult for specific country factors to create broader contagion to the whole emerging market equity universe.
Access to the asset class There is a tendency to treat all emerging markets as a homogenous group – countries with high economic potential but with higher risk and weak governance. While there are some common factors across the group of countries, this assessment masks significant variation between countries by most measures – population demographics, currency vulnerability, political regime and stage of economic development to name but a few.
Resultantly we should acknowledge that the average return for emerging market equities will disguise a wide range of performance. We also think that a lot of the additional volatility from emerging market equities tends to be these markets overshooting fundamentals. In light of this, where governance structures and time horizons permit, we believe clients’ best route of access into emerging markets are from our most unconstrained and nimble managers, and those most able to express their views.
We favour managers that can meaningfully allocate to areas of highest conviction, often most aligned to the thesis of emerging market investing, irrespective of benchmark allocation; China A-Shares represent one such present area.
In the current market environment, we consequently favour managers focused on more domesticallyexposed, high-quality companies, where profitability is driven by strong return on capital rather than financial engineering, particularly if it is driven by high levels of foreign-currency denominated debt.
James Jackson, senior equity manager researcher and Derry Pickford, asset allocation specialist at Aon
