Emerging markets exceed expectations

Janine Mace looks at a better-than-expected performance of emerging markets, though challenges still remain.

With the prospects for developed markets looking downright dull, emerging market equities may be one of the few bright spots for investors seeking growth in 2013.

Unlike their developed market counterparts, these markets are actually forecast to grow strongly.

In December, the International Monetary Fund forecast emerging markets would grow 5.6 per cent this year, compared to 3.6 per cent for the global economy.

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Developed markets on the other hand, are predicted to eke out only a measly 1.6 per cent.

Lonsec senior investment analyst Steven Sweeney believes the prospects for emerging markets are positive and argues the asset class looks far more attractive than it did 12 months ago.

“There is still a bit of uncertainty, but also increasing optimism,” he explains.

“European sovereign debt and the US ‘fiscal cliff’ are occupying investors’ minds, but provided there is no escalation, the outlook looks pretty positive.”

Emerging markets perform

Confidence about the outlook for emerging market equities is bolstered by their performance in 2012.

Although the MSCI World Index turned in a 13 per cent performance in 2012, the MSCI Emerging Markets Index finished up 14.52 per cent and the MSCI Emerging Markets Small Cap Index achieved an impressive 18.56 per cent.

This was a big improvement on 2011, when the two indices ended the year with a disappointing -20.41 per cent and -28.78 per cent respectively.

Sweeney admits it has been a volatile ride, but says in 2012 emerging market investors were “rewarded for their perseverance”.

Schroder Investment Management’s London-based head of global emerging market equities, Allan Conway, believes the outperformance of emerging markets is likely to continue in 2013. 

“Our view is to expect emerging markets to continue to outperform developed markets, but absolute returns will be hampered by US and European problems,” he says.

Sweeney believes the signs are encouraging in the macro environment, particularly with the Chinese slowdown bottoming and an apparent ‘soft landing’ achieved.

“US equities had a great run and the housing market is increasingly emerging from its slumber and manufacturing is picking up. The accommodative monetary policy is helping to drive markets globally,” he notes.

“European markets seem OK, so that gives hope for emerging markets.”

The flood of cheap money courtesy of the governments in developed markets seeking to encourage economic growth is also likely to have an impact on emerging markets, according to Premium China Funds’ associate director Jonathan Wu. 

“Emerging market equities will do reasonably well, as after every quantitative easing (QE), they have recovered quite strongly,” he says. To support his view he cites the 45 per cent emerging market rally after the first round of QE by the US Federal Reserve. 

Challenges remain

Stuart James, senior investment specialist at Aberdeen Asset Management, agrees the outlook is positive, but is a little cautious.

“The next 12-18 months will be quite challenging for emerging market equities, as it will be for most global equities,” he says.

“Despite the noise, emerging markets have performed reasonably well and possibly run a little ahead of themselves. Many underlying issues remain and the market this year is likely to be relatively flat and muted, with the potential for risk on/risk off events to occur.”

Conway agrees challenges remain.

“It is a frustrating situation. If the world was only emerging market countries, the outlook would be superb. Their economic fundamentals are very strong, prospective price-to-earning ratios are under 10 and there is good economic growth,” he notes.

“In the past when emerging markets were this cheap, they had a 40 per cent to 60 per cent rally. If the world was only emerging markets then a 20 per cent to 30 per cent return would be forecast, but with all the problems coming from Europe, the US and Japan and the hang-over from the GFC, this will continue to undermine investors’ confidence.”

He believes the underlying issues in Europe remain something of a drag on emerging market prospects. “Europe has very limited impact on Hungarian or Chinese exports, but a very significant impact on investor sentiment.”

The ongoing US debt problems are also likely to weigh on emerging markets.

“We will see ongoing volatile periods of heightened concern and a rollercoaster ride with investor confidence remaining fragile, but we still expect emerging market equities to outperform developed market equities,” Conway says.

In fact, James believes any volatility this year may offer retail investors an attractive environment to enter the asset class.

“The long-term story for 18-plus months remains robust. Emerging markets will be buffeted by global events, but that means there will possibly be buying opportunities,” he notes.

“Emerging markets are 17 per cent to 18 per cent cheaper than developed markets, but there will be some bumps along the way. Investors need to focus on the long-term and they can take advantage of the relatively attractive price points as buying opportunities.”

James acknowledges factors such as quantitative easing and talk of international ‘currency wars’ can be unsettling, but he believes they do not outweigh the benefits of investing into growing countries and companies.

“These issues do matter in the short-term, but they don’t change fundamentally the emerging market growth story. They create buying opportunities as markets overreact to pieces of news,” he argues.

“Investors should look to utilise volatility rather than be scared of it. Consider using dollar cost averaging into emerging markets and take a long-term view. You can’t wait for the bottom to be clear, as these markets can move very quickly.”

Home or away?

Experts believe that, despite their volatility, emerging market equities currently offer better pricing and growth prospects than the local market.

“On a relative basis, emerging market equities are trading at a cheaper price than the Australian market,” Wu says. 

“People have chased Telstra and the big four banks to death for yield. For local companies only operating in Australia, it is difficult to see how much more growth can they generate.”

By way of example, he points to the Australia financial services sector, which is facing far more constrained growth than in recent years.

Wu believes there are far more attractive growth opportunities in the financial services sector in emerging markets.

“The Australian market is exhausted. We have seen Westpac CEO Gail Kelly, talk about the days of 20 per cent-plus growth being over and only predicting low single-digit growth. We have some critical mass issues in Australia,” he argues.

Wu believes emerging market equities can also be attractive for Australian investors who traditionally invest locally to receive franking credits. 

“If you invest offshore and hedge it, then you get most of the return back. It is similar to franking credits and you get a similar imputation result,” he explains.

Once advisers become more comfortable with emerging market equities, Sweeney also expects them to begin embracing the growing universe of emerging market debt assets.

“The debt side is interesting and there is not yet much retail exposure to it. In five to 10 years there will be increased product availability in this area,” he says.

“We are seeing an increasingly deep pool for corporate debt in emerging market companies – some of which can be a better credit risk than developed market companies as they have stronger balance sheets.”

This year, however, the outlook is not particularly appealing after a strong performance last year.

“Whenever QE comes in, the face value of emerging market debt sees big flows by institutional investors and this occurred throughout 2012,” Wu explains.

“Emerging market debt did very well in 2012. But now a lot of people are set, it is not likely to see a rally, although we will see good solid yield.”

Conway agrees the outlook is not particularly attractive. “Debt spreads are down and emerging market debt looks very expensive. In fact, debt looks very expensive generally.”