A period of adverse sentiment towards emerging markets could create opportunities for investors to get on board at attractive valuations, the author of this article says.

The following article is by Kevin Gibson, chief investment officer at Eastspring Investments, an international firm which had $140.3 billion in assets under management at the end of June. (To see a recent commentary by the firm, click here.) The editors of this publication are pleased to share these views and invite readers’ responses. This news service does not necessarily endorse all the views expressed.

Years of negative sentiment about emerging market equities are drawing to a close as both investor perceptions and performance show major improvements.

This creates a window of opportunity for investors as valuations take time to catch up with the new reality. Equities are currently trading at levels that have been shown in the past to deliver substantial returns.

History teaches, however, that when emerging market equities correct, they do so rapidly and without much warning. In other words, that window will start to close.

If being shut out of the emerging market story is one danger for investors, another would be to treat this as a single, undifferentiated asset class. That would be a mistake, given that there are widely differing performances across the emerging market landscape.

Thus Latin America has recovered strongly this year from depressed valuations, rising in the seven months to the end of July by more than 30 per cent in US dollar terms led by Brazil and Argentina. Russian equities have also staged a recovery, leading the Europe, Middle East and Africa region to an 18 per cent rise in US dollar terms, despite volatility and geopolitical tensions.

By contrast, South Africa has been one of the worst performers, down 7.7 per cent to the end of July as the rand devalued by 6 per cent after the ruling African National Congress lost control in local elections of the municipal administration in cities including Johannesburg and the capital, Pretoria.

There are wide differences even within the same region, as can be seen in emerging Asia. It accounts for 70 per cent of global emerging market equities and experienced a rise of about 7 per cent in US dollar terms in the first seven months of this year. However, that figure conceals some very wide variations, from the Indonesian and Thai markets, up about 20 per cent, through a more modest 7 per cent for India to minus 1 per cent for China.

But nothing stands still in emerging market equities, and come August, the Chinese market, for example, was rallying, helped on its way by official approval for the long-awaited link-up between the Shenzhen and Hong Kong stock exchanges.

The big emerging market theme this year has been the willingness of investors once more to take on riskier assets, not least because developed economy markets are highly priced at a time when earnings and profits seem to be stalling.
 

Investors should be able to see that the risks, both macroeconomic and geopolitical, facing emerging market stocks are priced in, thus valuations already take account of such potential hazards as the “normalisation” of US monetary policy, the chances of a further slowing of the Chinese economy and the downward trend in commodity prices.

But because too many investors do not appear to see this, emerging market stocks overall trade at a substantial discount to where history suggests they ought to be. This should not, however, be taken as a signal to pile indiscriminately into this market. Yes, there are early signs of improvements in earnings and profitability, which ought to support valuations, but just as there are some stock markets in this sector offering significantly better returns than others, so there is a wide gap between the expensive and the cheap when it comes to individual shares.

Successful investment requires identifying those companies whose shares have been mispriced and investing accordingly.

Different sectors, too, have seen their performances diverge. For example, in the eight months to August, consumer goods companies, financial services firms and materials businesses did well while telecommunications companies and utilities did less so.

Overall, however, we firmly believe that the backdrop for emerging market equities has improved and is continuing to do so, and that this will drive a change in investor sentiment.

The developed world economies are gathering pace, led by the US, and while good news from the eurozone is harder to come by, Germany and Spain, to take two examples, are leading the way for the single-currency bloc.

This adds up to a more positive climate for emerging market equities, as does the tenacity of the Chinese authorities both in stimulating activity through loose credit conditions and in sticking to their programme of rebalancing the economy away from over-reliance on exports and investment and towards a greater emphasis on domestic consumption.

As we saw earlier, the Chinese market rallied in August.

To sum up, we are already seeing significant assets flowing into emerging market equities, and we expect prices to continue to rally. Successful investing in this new climate will call for a discerning approach that seeks value and avoids overpriced stocks.