Emerging markets ripe for opportunistic investors

Emerging markets have endured a bumpy road in recent years with low returns characterising much of 2015 and 2016, but now is the time to invest smarter not harder, and take a bit of risk, Hope William-Smith finds.

The overall emerging market sector has had mixed results over the last decade, but new opportunities are now set to emerge and growth has bounced back following a particularly lacklustre five-year period. 

According to data from FE Analytics, at 31 May 2017 the average returns for emerging market share funds were 20.89 per cent for one year, 8.07 per cent for three years, and 9.13 per cent for five years – a jump experts say is extortionate enough to coax even the most scathing investors to dip their toes in offshore waters.

The driver of this growth has been the strong underlying economic performance of emerging market countries against the plateaued growth environment of many in the developed world since the last time Money Management considered emerging markets in early 2016. 

The current investment landscape is competitive and attractive for emerging markets, and experts believe the time to act is now. 

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The string of controversial geopolitical developments from Brexit, to the results of both the US and European elections in the past 12 months could see the boost in emerging markets returns prematurely stunted, meaning investors may have just a small window of opportunity to jump through.

Planning ahead

Sydney-based specialist emerging markets asset manager, Remerga’s chief investment officer and director, Craig Mercer said growth opportunities in the sector were plentiful, and the short-term outlook was particularly promising.

“At this time, emerging markets present a compelling investment opportunity in aggregate, but the devil is in the detail,” he said.

“On an inflation-adjusted basis, forward earnings multiples are half that of their developed counterparts, with better underpinning levers for growth, less leverage and similar profitability.”

Lazard Asset Management’s ‘Outlook on Emerging Markets’ report for July 2017, called the current environment positive, and confirmed the early signs of a bull market supported by strong economic conditions and continued improvement for emerging markets.

Technology stocks rose 18.5 per cent in US dollar terms for the last financial year with tech-dominant Asian markets recording the highest growth, while many emerging market countries and companies reduced debt in the current low interest rate environment. This has led to contained inflation, stabilisation of currency, and earnings upgrades outnumbering earnings downgrades.

Lazard portfolio manager and analyst, Rohit Chopra, said: “Many of the structural headwinds that put off investors in recent years, primarily large current account deficits and weak currencies, have faded”.

“Reflationary developed markets policies should continue to lift return expectations and drive a recovery in investment growth…and the investor base could be more stable today as the challenges of 2013 to 2015 have tested investors’ tolerance,” he said.

Whether investors choose stocks, bonds, or currency, Standard Life Investments senior emerging markets economist, Alex Wolf said emerging markets had a tangible range of safe and more risky investments spaces across multiple countries and sectors to suit every investor.

“Any investor with the right risk and return profile would be suited to EM [emerging markets] investing,” he said.

“There aren’t any definitive ‘no go’ countries, it just depends what type of exposure investors are looking for.”
For Australian investors, 4D Infrastructure global portfolio manager and chief investment officer, Sarah Shaw said consideration had to come objectively from every angle.

“Emerging market opportunities need to be considered based on the country’s macro, fiscal, and sovereign position, as well as the infrastructure assets in place and in planning, and the regulatory or contractual framework governing private sector investment in these assets,” she said.

“Every country, sector, and company is assessed on an individual basis…and EMs will be a key global growth engine for decades to come.”

Macroeconomic outlook

The evolution of the economies of China and India and the new dominance of Indonesia has confirmed that Asia should be the dominant focal point for investors as they would need to look beyond geopolitical tensions in Europe and the US moving forward.

“China, India, and Indonesia account for 40 per cent of the world’s population and the evolution of their economies will have a significant impact on global growth profiles,” Shaw said.

“At the moment our core emerging market exposure is in Brazil, Mexico, China, and Indonesia where we see an attractive risk/reward trade off.”

Wolf also gave weight to India thanks to its durability.

“Large scale reforms such as the GST [goods and services tax] which turns India into a unified market for the first time… can help catalyse India’s positive demographic trends allowing the country to see sustained growth outperformance,” he said.

“As far as growth is concerned, India can and should strengthen from its current pace.”

Shaw said investors could capitalise on India’s promising political scene for a good return investment closer to home, but also pointed towards South-East Asian competitors which could offer opportunities for infrastructure and agriculture investments.

“While certain countries may look great from a macro perspective, regulation may not be supportive and vice versa,” she said.

“Significant opportunities [are] emerging in Indonesia as they establish a major infrastructure program; India looks interesting under the current government, although execution is still being tested.”

Shaw said investors should make sure not to discount emerging markets in South America, particularly front runner Brazil which held burgeoning choice in the aircraft, machinery, iron ore, agriculture, and chemicals spaces.

“Brazil is undervalued due to ongoing political risk, however, the macro is recovering and Brazil has proven itself to have a very independent court system supporting the contractual/regulatory environment governing infrastructure, she said.

Offshore options

With many emerging market regions now home to higher rates of economic growth than traditionally secure developed economies, cautious Australian investors have become more open to the draw of offshore opportunities.

“Emerging markets are home to some of the fastest growing economies and most exciting companies in the world, and they offer a differentiated return pattern for Australian investors,” Chopra said.

“Australian investors on the whole are underweight in their allocation to emerging markets, and like many investors around the world have a strong home bias, but a globally diversified portfolio should include some exposure.”

Even the smallest markets could be a catch, with Wolf pointing away from South America and Europe.

“Smaller or frontier markets such as Vietnam and sub-Saharan Africa have received less attention despite rapid growth rates, positive demographic trends, and reform efforts,” he said.

“These emerging markets have become more resilient. They are less dependent on developed markets growth and less correlated with commodity prices.”

Mercer said investors should tread carefully but should pay attention to the Middle Eastern and African markets as they were on track to develop rapidly over the long-term.

“Over the next 30 years the Indian sub-continent and a group of African countries will be the most populous places on earth and while this presents opportunities for growth it comes with material risk of governance failures and corruption,” he said.

Multi-strategy approach

While investors of all maturities were well-positioned to take advantage of emerging markets, many still draw a blank on effective strategies for utilising these riskier-than-average assets within a portfolio. 

A solid strategy was key to making snappy market decisions, which Mercer said were more likely if investors heeded advice and considered multiple indicators.

“The key to outperformance in the emerging markets is to place emphasis on the alignments of interest to minority shareholders and the broad sustainability practices of a company,” he said.

“Then and only then, assess the company’s fundamentals.”

According to India Avenue Investment Management managing director, Mugunthan Siva, a one-way path to lucrative yield could be found by looking outside the best performing emerging market companies.

“Aussie investors need to be careful they pick the right strategy when investing – for example, passive approaches may be fashionable for accessing developed equity markets in Australia,” he said.

“This doesn’t necessarily apply in markets like India, where passive strategies have been shown to underperform active management. There’s huge scope to find value when you look.”

Shaw said a portfolio which included emerging market infrastructure investment was a strong option for diversification as low volatility, particularly in Asia, confirmed strong returns would remain possible in the short-term.

“Emerging market infrastructure is underpinned by contract or regulation and directly linked to the in-country domestic demand story and the emergence of the middle class, while hedging against common EM risk, namely inflationary spike,” she said.

“Over the last 10 to 15 years emerging market infrastructure has offered investors better returns than general emerging market equites at lower volatility than the broader market.”

Building diversification

Investments in emerging economies will continue to change over the next 12 months with a shift away from the four big BRIC markets of Brazil, Russia, India and China, and fund managers would be largely responsible for how and where dollars are invested as even smaller markets continue to rise.

Despite the potential for emerging markets to go back to mediocre performance thanks to policy uncertainties, Wolf said a little bite of every apple was still hailed as a clever approach.

“Diversification has always been a good thing and even during a period when EM growth was under pressure there were still opportunities to diversify and achieve positive returns, he said.

Chopra said emerging markets were now so strongly entrenched as an available option in the developed world, that portfolio diversification was a given for success.

“The debt and currency markets in particular have matured significantly in the last decade and many investors now have both EM equity and EM debt allocations,” he said.

“Strategies can combine debt, currency, and equity in one portfolio [and] this approach can smooth out some of the volatility, but still give you access to the emerging markets growth story.”