Will emerging markets shine again?

Emerging markets have not experienced any shining glory of late, instead falling into a dark abyss scented with the unmistaken odour of unwanted and unloved investments.

According to van Eyk Research’s head of research, Tom Cottam, emerging markets are fundamentally out of favour as an investment category because they are high risk.

They are considered a high-risk investment because of the vulnerability of developing nations to ill-fated political, financial and social events such as the Asian market crisis and the recent economic upheaval in Argentina. Cottam says such events have helped to push emerging markets investments even further away from investors.

“Half of emerging markets reside in Asia so that has put people off a bit,” he says.

Emerging markets have experienced heydays in the past, including a peak in 1994 with the Asian boom.

However like other investment sectors, emerging markets are cyclical because emerging economies respond differently to global recession. For example, the 1994 peak was directly followed by a slump when the economy reacted to the Asian crisis and the Russian debt crisis.

The ING Barings Emerging Markets Index shows peaks in emerging markets investments during 1994 and 1997, when the index hit its highest point. Immediately following these peaks the index shows a drop in the investment in emerging markets, with the lowest point less than a year later.

Cottam says the past can provide insights into the future direction of this investment sector — back 100 years ago when China and India were the two largest economies, and before the growth of the US as the world’s major financial player.

“As the US matures, China could emerge as the biggest economy, say in 10 to 20 years time, with India as the next biggest,” Cottam says.

Globalisation and access to technology and products will play an important role in the future state of nations.

“The state of the economy is based on the size of the population and there is a case for having strategic investments in China and India,” he says.

Overall, Cottam says emerging market investments tend to be popular when the economy is buoyant. The heavy investment by emerging markets in soft commodities will respond well to global economic recovery and increasing commodity demand.

So when will the world economy get back to normal, and emerging markets given the chance to be rediscovered and loved again?

“The consensus view is this will happen in the second quarter of next year,” Cottam says.

For GMO Australia executive director Paul Chadwick, the time to invest in emerging markets is now.

“By their nature, emerging markets are cyclical and we think they are the best value now,” he says.

While Chadwick agrees emerging markets is an unloved asset class when looking at the big picture, he says recently it has enjoyed a renewed popularity.

“[Emerging markets] differential performance over the past year has increased,” he says.

While the crises in Mexico, Asia, Russia and Argentina have seen emerging markets investments plummet from their peak, diversification is still the essential ingredient for institutional investors.

“It’s a feature of the landscape but also why institutional investors should have a strategic investment in emerging markets. Our general position is investments in emerging markets decreases overall risk through the diversification and improves robustness,” Chadwick says.

While he estimates most of GMO’s institutional investors have five to 10 per cent of their total portfolio invested in emerging markets, Cottam says the degree of exposure for retail investors depends on an individual’s tolerance to risk.

He believes the ‘mum and dad’ investors holding a 20 to 30 per cent exposure in international equities should have a 10 to 15 per cent investment in emerging markets, representing a four per cent exposure of the total portfolio.

“It is a riskier investment but could provide the spice,” he says.

The level of exposure jumps for high net worth retail clients, with Cottam suggesting a 20 per cent holding. He says a particular area of interest is emerging market debt.

Chadwick says the key points for the return to favour of emerging markets as an asset class can be found with the normal valuation methodology people use. That is, that emerging markets are generally cheaper to buy.

“Emerging markets are nearly as cheap as they’ve ever been, whereas developed markets are the most expensive they’ve ever been,” he says.