Emerging markets reality check

Graham Smith
Graham Smith
Market Commentator16 May 2018

What a difference a change of year seems to make. While 2017 was all about subsiding economic and geopolitical risks opening the way to strong stock market gains, the re-emergence of old economic fragilities have been a point of focus so far this year.

Nowhere has this been truer than in Argentina. Apparently entering a new era of fiscal responsibility and economic openness in 2017 under the two-year-old presidency of pro-reformist Mauricio Macri, Argentina has since fallen back into the clutches of market fear.

Argentina’s peso plunged last month, forcing the central bank to raise interest rates to 40% in an effort to stem the tide of money out of pesos into dollars. Then, last week, President Macri felt compelled to apply to the IMF for a bailout1.

The problem, it seems, has been a sudden loss of confidence in his ability to bring about real change. Pressures on the home front have certainly been extreme. Violent protests accompanied changes to pension laws last December and planned labour market reforms were scaled back in January.

You might argue, however, that a recent change in sentiment towards the US is more than a trivial coincidence. With yields on 10-year US Treasuries continuing to test a psychologically important 3%, the dollar rising and further rises in interest rates pencilled in for 2018/19, emerging markets have to work harder to prise investors away from US assets2.

Protectionist threats also work against emerging markets, which depend on easy trade conditions to meet their considerable growth potential. It’s no wonder then some cracks are beginning to show.

So it’s probably no coincidence either that Turkey is also under severe pressure. Again, government policy is partly to blame, this time with markets worried that Turkey’s President Erdogan is taking his country at pace in the wrong direction.

Interest rates are too low to contain inflation and the country has been suffering from a dire combination of too few exports and too much government spending. With the Turkish lira now tumbling as a result, concerns are growing that servicing the country’s foreign currency debts could become unmanageable3.

What these events have in common is a demonstration of the importance of politics. One way of looking at emerging markets is through the eyeglass of “PEST” theory. This acronym usually describes what some consider the four most important factors affecting companies and their products – politics being first, followed by economics, society and technology.

Clearly, such selectivity is less important when global sentiment is strong, as it was last year. That’s not the case now though – it certainly looks as if investors are becoming increasingly choosy.

In a broader sense, that may ultimately prove a good thing. It reduces the likelihood that difficulties in individual countries like Argentina and Turkey lead to the kind of contagion that spread through emerging markets in the mid-to-late 1990s.

Positively, while Argentina and Turkey languish, other markets are performing quite well – Brazil and Russia, for instance, buoyed by a rising oil price – and India too4.

For long term investors especially, emerging markets can serve a useful purpose. Over time, premium growth rates stand to outweigh the negative impact of short term casualties and fluctuations in sentiment.

The International Monetary Fund says it expects emerging markets to grow by 5.3% both this year and next5. That’s important, because it was growth that helped them to prosper even as US interest rates were rising between 2004 and 20066.

You might expect emerging markets growth to come at a price, but it still doesn’t, even after a year of good market gains. At the end of last month, the MSCI Emerging Markets Index traded on 14.5 times the earnings of the companies it represents, compared with almost 20 times for world markets generally7.

Clearly, the mismatch between growth and price can be accounted for by justifiable caution about the risks involved. Since political and economic crises have always been notoriously difficult to predict in the past and corporate transparency can be found wanting in some countries, an active, diversified investment approach remains sensible for most investors.  

That might especially be true as investors begin to explore the “next generation” of emerging markets – the “MINTs” – of which Turkey is one.

Like the BRIC countries – Brazil, Russia, India, China – that preceded them in the popularity stakes, Mexico, Indonesia, Nigeria and Turkey are a diverse group of countries undoubtedly awash with opportunities and great demographics, but risks too.  

Fidelity’s Select 50 list of favourite funds contains three that invest in a diverse range of emerging markets with a strong focus on stock selection.

Arising from that “bottom-up” approach, the Fidelity Global Emerging Markets Fund currently features large holdings in technology and financial services companies, with Naspers (South Africa) Sberbank (Russia) HDFC (India) and AIA Group (Hong Kong) featuring prominently.

Consumer defensives are in strong evidence in the Janus Henderson Emerging Market Opportunities Fund, currently with top-10 holdings in Tiger Brands (South Africa) Uni-President (Taiwan) United Breweries (Chile) and Heineken.

Sources:

1 FT, 10.05.18

2 Bloomberg, 15.05.18

3 Bloomberg, 14.05.18

4 Bloomberg, 15.05.18

5 IMF, January 2018

6,7 MSCI, 30.04.18


Important Information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.