Sunshine after the rain: can emerging market equities overcome their recent stumble?

Emerging market equities are no longer the darling of the investment world and just a quick look at returns makes it easy to see why.

“The average long-term valuation for emerging markets is two times price to book. Currently we are 1.6 times. This is a time investors should be accumulating exposure to emerging markets.”

Emily Whiting

The MSCI Emerging Markets index for the year to 17 June 2013 returned -9.29% compared with 10.35% from the MSCI World, which measures developed markets, over the same period.

Such negative performance is already driving investors out of the emerging regions. A June 2013 survey of 190 global fund managers with $572bn (£365bn) in assets under management, conducted by Bank of America- Merrill Lynch, found the lowest levels of exposure to the emerging markets since December 2008. Respondents were a net 9% underweight compared with a 43% overweight position in February.

However, looking at the long-term performance, which is of course what the majority of pension funds should be doing, the story is rather different. Emerging markets have far outperformed their developed world counterparts (see table one) over the last decade and it is really only in the past three years that they have started to lag.

Drivers for the lull

A number of factors have coincided to cause the slowdown in emerging stock market returns with the developing regions appearing to be victims of unfortunate timing and circumstance.

The first, and perhaps most critical factor, is the deceleration of Chinese growth. In May, Bank of America-Merrill Lynch shaved its growth forecast by four basis points to 7.6%, while in April ING reduced its growth expectations from a robust 9% to a less dazzling 7.8%.

A second challenge comes from the Fed’s propsed tapering of quantitative easing and the strengthening US dollar. Typically, emerging market equities have outperformed most consistently during periods of dollar weakness since a weak dollar usually coincides with rising commodity prices and a rising appetite for risk. Conversely when the dollar is strong it is able to entice assets away from ‘riskier’ investments such as those in the emerging markets.

William Calvert, manager of Polar Capital’s emerging markets funds, says: “A strong dollar negatively impacts emerging markets. When the dollar is going up it needs money flowing into it and that usually flows out of the emerging markets.”

Next is the fall off in commodity prices which has had a big impact on some of the largest emerging market members such as Brazil and Russia.

Calvert says: “Commodity prices have been very weak and, historically, there has been a strong correlation between commodity prices and emerging market performance.” The fourth challenge comes in the shape of economic policies implemented by certain emerging market central banks to help tackle inflation. For example, Brazil is facing inflation rates of 6.5% – against a 4.5% target – forcing it to raise its key interest rate by 0.50 points to 8% in a bid to control spiralling costs.

Emily Whiting, client portfolio manager for the emerging markets equity team at JP Morgan Asset Management, says: “Emerging markets have faced earnings headwinds over the last two years. Larger emerging economies have put inflation-fighting measures in place which have led to slower growth and lower profit margins.”

Finally, political and economic uncertainty in countries such as Turkey, Brazil and India do little to reassure investors of the future stability for emerging markets.