Australian institutional investors are extremely familiar with investing in emerging markets and, particularly, the opportunities they provide at different times in investment cycles to outperform the global developed or Australian markets.
However, when it comes to individual investors, be they self-directed or assisted by advisers and accountants, there is often less comfort with the prospect of investing in an asset class with the ‘emerging’ moniker.
Indeed for many it’s not readily apparent what countries or markets are included in the term emerging markets, which is frequently simply referred to as EM.
The definition with the greatest acceptance and currency is that determined by the MSCI Emerging Markets Index, which most EM managers use as their benchmark to judge performance or as a tool to simply ‘buy the market’ if their investment style is passive rather than active.
The MSCI Emerging Markets Index comprises 24 countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Malaysia, Mexico, Qatar, Pakistan, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey and United Arab Emirates.
We believe now is a time when individual investors could do well by diversifying their equity portfolio beyond the Australian Securities Exchange to include exposure to EM and, in particular, active exposure to EM.
EM update and outlook
We currently see EM entering a more virtuous environment. EM equities posted a strong January, extending their 2017 gains. Volatility has returned to global equities in 2018, however, and emerging markets have been no exception. Although the MSCI Emerging Markets Index weakened in February and March, it rose more than 1 per cent in the first quarter in contrast to key developed market equity indices, which retreated slightly. However, certain EM countries were caught in the crosshairs of trade tension, notably China, whose mainland equity market finished down more than 4 per cent for the quarter.
The prospect of rising inflation, rate hikes, a stronger United States dollar and a trade war remain prime sources of this increase in volatility for global and EM equities. It is notable that EM volatility still remains below average and only began to rise in February from unusually low levels in 2017. More importantly, we are experiencing inflation of a ‘good’ kind, underpinned by economic growth. In our experience, slow, steady global growth of the type we have today is the best possible backdrop for EM equities.
In a world where relatively few financial assets can be considered cheap, we believe emerging markets offer the greatest value. They offer the lowest valuation of any major equity region, with comparable or better return on equity and dividend yield. The natural enemies of EM are in retreat: the risk of negative real growth has greatly receded and the world is free of major crisis. Importantly, company fundamentals continue to improve across most countries and sectors.
Earnings growth expectations were revised higher throughout the first quarter and returns were more broadly based, led by energy, healthcare and financials securities. Global protectionism is currently our biggest concern for the asset class. That aside, EM equities are showing signs of improvement from a profitability, dividend yield and free cash-flow perspective after a period of rebalancing. At the end of March, EM equities traded at about a 25 per cent price-to-earnings discount to developed markets. This is a narrower discount and an improvement from last year.
The issue of Russia has dominated headlines in recent weeks and clearly there are geopolitical considerations in investing in Russia today. We still do find selective opportunities within Russia, but are increasing our political and macroeconomic risk discounts in light of increased geopolitical tensions.
While we see good bottom-up growth opportunities ahead, we also sense value tailwinds could begin to form and this would offer new leadership and a new area of opportunity within the asset class. Notably, we are seeing ‘rebirths’ among several energy and materials companies, which have lagged the broader recovery to date. Profitability is returning to many of these companies and debt burdens are declining, with many new projects now complete.
More than two years into the recovery, we continue to hold the opinion that EM equities offer investors an above-average opportunity.