Four reasons to be wary of Emerging Markets

After a prolonged spell in the wilderness relative to developed markets and a truly dreadful 2015 as the Dollar strengthened in expectation of the US starting to raise rates again, Emerging Market shares have staged quite a comeback during 2016 with the MSCI Emerging Markets Index delivering a total return (income reinvested) of 26.8% year-to-date in Sterling terms versus a 16.6% return from the MSCI World Index. That’s a far cry from the five-year performance, which saw the emerging market index eke out a 27.8% return while the MSCI World Index soared 110.8%.

The rebound in Emerging Market equities this year has been fuelled by a combination of a weakening of the Dollar versus the Yen in 2016 as the US Federal Reserve Bank paused on further interest rate hikes, commodity prices climbing of their low points which has relieved pressure on some of the resource heavy Emerging Markets, China engaging in yet more credit fuelled stimulus and excitement about the prospects for political reform in Latin America. Is it now the time to begin piling back into them? Jason Hollands, Managing Director of Tilney Bestinvest, shares his views on how to approach investing in the volatile sector.

“Capital inflows into the Emerging Markets have noticeably notched up over the summer. According to Goldman Sachs, inflows into actively managed Global Emerging Market equity funds in recent weeks represent the largest streak since February 2013. Emerging Market debt has also become increasingly popular, as investors have been prepared to take more risk in the desperate search for yield at a time when around a third of government bonds across the globe are now on negative yields.

“Despite this apparent cheeriness, we would still urge a caution towards emerging markets, for a variety of reasons:

1. A major risk for investors contemplating piling into EM is that the Dollar renews a strengthening trend

“A strong Dollar pushes up costs for emerging market countries and businesses that have borrowed heavily in Dollar-denominated debt as many have during the years of ultra-accommodative Fed policy and a rise in the Dollar also has the capacity to trigger capital outflows from these markets as funds are repatriated to Dollar assets. So, a halt to Dollar strengthening this year as the Fed has paused on further rate hikes has eased pressure on Emerging Markets.

“But market expectations are now pointing to a probability of a further US rate rise before year end. In recent days there has been considerable turbulence on the markets as fears of a Fed rate rise gathered pace last Friday, which were then subsequently quelled on Monday by dovish comments from Fed official Lael Brainard. While her statements have diminished fears of a rate rise being announced in September, investors should take note of how skittish markets will be to a rate rise. When the US tightens policy further, this could lead to a sharp reversal in the more buoyant performance we’ve seen from emerging markets this year.”

2. China remains a major concern

“While Chinese economic data for August released today for factory output and retail sales has beaten market expectations and on the surface suggests a stabilisation in the Chinese economy, investors should be very sceptical about how durable this is. Private investment is weak and China is becoming increasingly reliant on government spending to drive economic activity, much of which is of questionable efficiency and will lead to further overcapacity. As policy support from the last round of stimulus fades, more fundamental cracks in the Chinese economic model may well return to the fore. Chief amongst these concerns is the rapid expansion of credit in China to finance property and infrastructure investment, much of which has been provided through an opaque shadow banking system through the issuance of so-called ‘wealth management products’. In fact new credit is continuing to be created while non-performing loans are on the rise. While official policy is to rebalance China away from exporters and infrastructure investment towards developing the Chinese consumer, progress has been slow. There are some clear and worrying similarities between where China stands today and that of Japan in the early nineties: its demographic profile is set to deteriorate, equity valuations are high and its private sector debt build-up has been rapid. China represents a key systemic risk to global markets, more so than Brexit ever did in our view.”

3. Market euphoria over political reform is overdone.

“One of the hottest spots in the emerging market universe this year has been Latin America, which is dominated by Brazil. While we see the ditching of Dilma Rousseff as President of Brazil as a positive step given her disastrous mismanagement of the economy, capital markets have an unfortunate habit of being too bullish in their expectations around the pace of reforms that stem from political change. We have seen this in Japan, with the initial excitement about “Abenomics” has now faded, and to a lesser degree with the unrealistic level of expectations initially placed on Narendra Modi in India. In those two countries, the respective premiers came to office with strong popular mandates. Rousseff’s replacement in Brazil, Michel Temer, has no such mandate and he is facing stiff resistance from Rousseff’s supporters. The task of turning around this basket case economy will be a formidable one, with no quick fixes nor assurance of success.

4. Another tail risk for EM could be a Trump victory in November

“In the aftermath of the Democratic convention Trump’s polling numbers were trailing badly as he was dogged by critics from within the Republican camp. But he has been closing the gap and the impression that Hillary Clinton sought to hide health problems could impact the campaign. In the US, TV debates are often seen as key moments in Presidential campaigns and the first of these is set to happen later this month. It is too early to dismiss the prospect for a Trump victory. Why would this be bad for emerging markets? Firstly because Trump’s economic platform is to implement very aggressive tariffs on countries like China and Mexico, to protect American jobs. Secondly Trump advocates massive fiscal stimulus at home through deep tax cuts and infrastructure spending. These latter measures would likely see new Treasury bond issuance, encouraging capital to return to the US.

Hollands concludes: “While we believe emerging markets undoubtedly hold out long-term opportunities there are real risks in the near term and so investors should tread with care in chasing the recent rally. Those inclined to invest in these markets might consider a phased approach that drip feeds cash in over a period of several months to help mitigate potential volatility. Funds we like include Fidelity Emerging Markets (our top pick), Somerset Emerging Market Dividend Growth for a more conservative approach focused on businesses delivering a sustainable yield and JP Morgan Emerging Markets Investment Trust for investment trust fans. The latter has a major position in favour of India, which we see as a relative bright spot, benefitting from low oil prices (it is a net importer of oil) and where the Government has recently managed to get approval for a unified Goods & Service Tax which should simplify its tax system and lead to greater efficiency. For ardent advocates of passive strategies, a more cautious option than a traditional tracker is the iShares MSCI EM Minimum Volatility ETF. This has circa 250 holdings but reweights the index to give greater prominence to less volatile stocks.”

-ENDS-

Important information

The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested. Past performance is not a guide to future performance. This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.

Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should make yourself aware of these specific risks prior to investing. We aim to provide investors with information to help them make their own investment decisions although this should not be construed as advice or an investment recommendation. If you are unsure about the suitability of an investment or if you need advice on your specific requirements, we strongly suggest that you consider professional financial advice

Underlying investments in emerging markets are generally less well regulated than the UK. There is an increased chance of political and economic instability with less reliable custody, dealing and settlement arrangements. The market(s) can be less liquid. If a fund investing in markets is affected by currency exchange rates, the investment could both increase or decrease. These investments therefore carry more risk.

Investment trusts are similar to funds in that they provide a means of pooling your money but they are publicly listed companies whose shares are traded on the London Stock Exchange. The price of their shares will fluctuate according to investor demand and changes in the value of their underlying assets.

ETFs can be high risk and complex and may not be suitable for retail investors, so you should make sure you understand all the risks involved before investing.