Emerging Markets: Prepare for a Bump Before the Rally

Somerset's Mark Asquith warns that the Fed raising rates will cause a sell-off in emerging market equities, but after that the savvy money will see profits rise

Emma Wall 1 December, 2016 | 2:45PM
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Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Mark Asquith, manager of the Somerset Emerging Markets Small Cap Fund.

Hi, Mark.

Mark Asquith: Hi, Emma.

Wall: So, 2016 has been a pretty good year for emerging markets, hasn't it? What has dragged this rally up?

Asquith: Yes. At last, we've had a good year after a five, six-year drought. Some of the positive factors have been a reversion of negative factors and this is the big question. Is it just the reversion to a mean from a very ugly period or is it something more sustained and did we see some kind of bottom at the end of last year? We tend towards the latter view, but we'll see.

Countries like Brazil, South Africa and even India, which got quite hit last year, Brazil and South Africa particularly with the currencies, have staged really strong rally this year. And so, that has been a part of it. And China, which actually has had an effectively pegged or controlled pegged currency, which hasn't devalued perhaps to take account of some of the competitive factors going on, has had a worse year. And that's been very good for some of our positioning.

And certainly, you could see in some of the value opportunities that countries like Brazil and South Africa were both cheap and oversold on currency and on an equity basis.

Wall: You alluded there to the fact that there has been several negative years and is this just a mean reversion. We are still considerably lower than the levels we were at in 2009 in emerging markets. Does this mean that 2017 has further increases to come?

Asquith: Yes, I think, potentially. I mean, you can correct through severity or you can correct through duration and seven years certainly feels like duration. And the underlying issues have been the misallocation of capital, too much debt extended both through the banks and the bond markets to unsuitable borrowers within emerging. And in many countries, you've seen the NPL cycles begin to be undergone and some of the pain being taken.

I mean, India went into its NPL cycle probably about four years ago, some of the other countries later. China hasn't really dealt with its issues; it's swept them under the carpet. But many of the emerging markets have been taking the pain in the banking system. They have been making reforms. I mean, India with demonetization quite recently. Brazil and even some of the other emerging markets have been making efforts to turn around the macro. So, that's good.

I think the last thing that needs to happen is to get all the zombie industrials and the overcapacity taken out of the system. And for that you may need the nuclear weapon of higher interest rates or a higher cost of borrowing. You've seen some supply side reductions within commodities. It's not really about demand here. We don't have to worry about it. We just need to see this overcapacity being taken out. Then you can get some of these cyclical areas going back up again.

Wall: And that's key, isn't it, because emerging markets should never be looked at in isolation? They are very affected by what goes on in developed markets. And you alluded to it there with high interest rates. The Fed raising rates will really help to shake out some of the problems in emerging markets, won't it?

Asquith: It could happen that way; it could happen otherwise and there will be a period of intense pain. So, when it happens, there will be a panic. There will be lots of bankruptcies and markets will probably go down. But then you've got the few good quality cyclical or value companies poised probably for a long period of outperformance.

And everyone who is concentrated in the 30 to 40 times P/E consumer staples, safe quality growth stocks of whom there are vanishingly few, will be exposed by that I think. And we've got a polarity based portfolio where you've got both that quality and some cheap value. But there is a risk there in style outperformance and which styles really tend to do well.

Wall: So, I suppose the takeaway message for 2017 is, be prepared for a bump in the road. But if you look for well-valued good quality cyclicals, all will be well?

Asquith: Hopefully, yes. And I think generally emerging markets are reasonably well-positioned, at least in relative terms.

Wall: Mark, thank you very much.

Asquith: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
MI Somerset Emerg Mkts Sm Cp B Acc  

About Author

Emma Wall  is former Senior International Editor for Morningstar