Finding Investment Opportunities in Emerging Markets

Within emerging markets the Asian region provided the main winners in 2014 thanks to the sharp decline in the oil price. But what can investors expect from 2015?

Simon Dorricott 2 July, 2015 | 1:09PM
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Emerging market investors had a difficult time in 2014, with returns lagging developed markets. Over the year as a whole the MSCI AC World Index showed a total return of 8.6% in sterling terms against a meagre 1.4% return for the MSCI Emerging Markets Index. Within emerging markets the Asian region provided the main winners, with the sharp decline in the oil price seen in the latter part of the year being beneficial for the majority of countries in the region as they are net oil importers.

The election in Brazil led to a volatile market, while weak commodity prices had an adverse impact

Particularly strong performance was seen from the Indian market, which rose over 36% in sterling terms on the back of this and, more importantly, expectations surrounding the election win for Narendra Modi and his reform agenda. Positive returns were also seen from Chinese equities as investors continued to channel capital into the market, particularly A-Shares, despite the marked slowing of GDP growth resulting from the government’s attempts to rebalance the economy.

Latin American and EMEA returns were driven by declines in Brazil and Russia, the dominant equity markets in those regions. The election in Brazil led to a volatile ride for investors, while weak commodity prices had an adverse impact on large index constituents. Russia has of course also been significantly impacted by the sharp decline in the oil price, which fell almost 40% in the year. In combination with the Ukraine situation and sanctions, this led to a market decline of over 40% in sterling terms.

This variability in returns led to significant opportunities for talented active managers to outperform passive strategies. Within our rated universe of emerging markets funds, growth orientated strategies were the best performers, with those operating more valuation focused strategies generally being more exposed to Russia and less to India, with negative results over the year.

The Story So Far

The first quarter of 2015 has seen improved relative performance from emerging markets, with the MSCI AC World Index and the MSCI Emerging Markets Index performing largely in line. Within emerging markets, Asia again led the way as the majority of markets produced healthy gains.

China showed further outperformance, with the A-share market continuing to perform very strongly on the back of high volumes. Investors there have maintained a focus on stimulus measures, such as looser monetary policy, rather than near term data pointing to slowing economic growth. In addition, India continued to perform well as the central bank boosted the positive sentiment surrounding the country by cutting interest rates.

The EMEA region also posted positive returns over Q1 2015. Tensions resulting from the Russia-Ukraine situation dissipated during the quarter and with energy prices stabilising, Russian equities and the currency both gained ground. There have, however, also been negatives for this region, most notably Greece and Turkey. In the former there were concerns over the ability of the newly elected government to reach a timely agreement with its creditors, while in Turkey comments made by the president, Recep Erdogan, concerning interest rate policy unsettled markets.

The Latin American region was the laggard over the quarter, primarily due to Brazil. The equity market and currency have been impacted by a range of factors, including the fraud investigations at Petrobras, lower iron ore prices, rising unemployment, austerity measures and the general state of the economy which could lead to a credit rating downgrade.

In terms of the outlook, most investment managers highlight the overall attractiveness of emerging markets in terms of valuations, particularly in terms of P/E ratios relative to developed markets. They point to good corporate profitability and relatively high levels of economic growth across many countries, albeit with the exception of Russia and Brazil in the near term. The overall cheapness of the region does, however, mask the fact that there are also areas of high valuations, particularly within internet related names, healthcare and consumer sectors, where investors have continued to buy into visible growth stories. The rise in such names has generally been at the expense of commodity and economically sensitive areas.

Invest in China or India?

The China A-share market is an area that has been receiving a lot of attention recently and has seen huge volumes and increased valuations as domestic investors have sought a home for capital, particularly given the declines in the domestic property market. For foreign investment managers Shanghai-Hong Kong Connect has opened a new way of accessing this market, but as yet we have seen few managers in the UK making use of this. The majority have increased research resources, but for most operational issues remain and the rise in the market has made many stocks unattractive. That said this is clearly an area where we are likely to see greater participation in the future.

The rise of the Indian equity market has also seen a few managers question valuation levels in some of their holdings, but we have not yet seen reduced allocations to this market. In general the outlook for growth is deemed strong in absolute, and more particularly, relative terms. Managers are therefore unwilling to take profits here given the limited longer term growth opportunities they see in many markets and their continued belief in the reformist policies implemented by the government. The low oil price and recent loosening of monetary policy have provided further positives.

The Impact of Commodity Prices

Finally, we come to commodity prices, the impact of which can be significant as we have seen recently with regard to the oil price. It is, however, interesting to look at the make-up of the MSCI Emerging Markets Index when assessing the current impact on the overall region. Clearly an increase in the price of oil would have a welcome positive impact on the economies of both Russia and Brazil among others, but these countries account for just around 11% of the index, with over 65% of the index being in Asia, a net-importer of oil and a beneficiary of lower oil prices. Looking forward, most commentators believe the spot price will rise, but estimates of the magnitude of this rise in the short term have been reducing as inventory levels are high.

This article originally appeared in International Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Simon Dorricott  is a Senior Fund Analyst for Morningstar

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