Dewi John: Lots of chaff, some wheat in emerging markets

It’s been a hard year for equity markets, and an even harder one for emerging market equity markets. Last year, emerging markets were tipped to benefit from the post-pandemic take-off in demand, with even a post-pandemic reversion to mean by the global economy being seen to disproportionally benefit emerging markets.

To twist an old saying, if you want to make the gods laugh, show them your investment outlook 12 months out. There have, of course, been a whole toolbox-worth of spanners thrown in the works, from war in Ukraine and China facing ongoing difficulties due to Covid-induced supply chain bottlenecks and a crisis-ridden property sector. That said, India, frontier markets, and Middle East and North Africa performed well over 2021, while India and Latin America have outperformed the MSCI World Index over 12 months. Nevertheless, the largest part of the EM index is China, and saving a strong summer bounce, it continues to struggle—though not as much as emerging Europe, for obvious reasons.

This volatility is reflected in investor sentiment. While net flows into the IA emerging markets sector have been around £2.3bn over three years, net outflows over the three months to end-August are £1.9bn. Nevertheless, this is not unique to emerging markets, with £4.6bn and £4.7bn being withdrawn from Global and UK All Companies equity funds over the same period.

Looking at diversified emerging market funds, Lipper’s emerging market equity classification, three-year returns to the end of August range from 46.7% to -28.6%, while one-year returns go from 17.2% to -47%, although these two datapoints are themselves something of outliers. The top-performing fund over the year—the Fiera Oaks EM Select Fund—has a country allocation very different to the pack, with Saudi Arabia and Vietnam making up more than 36%; as does second-placed BNY Mellon Emerging Income, which has only a 7.7% allocation to China. The tilt towards income stocks will no doubt also have served the latter well over the past year, which investors are picking up in their asset allocations more broadly, as we have seen outflows from previously favoured equity global, with equity global income picking up some of this.

Likewise, over three years, top-placed St. James’s Place Emerging Markets Equity’s largest exposure is 22.7% to the Philippines. So, it pays to be different…at least for some, as the Lipper Global Equity Emerging Markets classification average has underperformed the MSCI Emerging Markets Index every year since 2017 in sterling terms.

I’ve also included the Lipper score for capital preservation, with ‘one’ being the lowest and ‘five’ the highest. There’s only one fund in the table with a ‘five’, although a further five are rated ‘four’. Given the bleak outlook over the coming months, the ability to preserve capital will likely have an enhanced importance. The market has fallen considerably, but it can still fall more.

Source: Lipper

Silver linings

There are some silver linings. JP Morgan analysts, for example, reckon that while Chinese equities are heavily out of favour, “the Chinese stock market has fallen 50% from last year’s peak and now trades at an attractive valuation. The near-term outlook looks especially tough as the government grapples with Covid-19 outbreaks that are exacerbating weakness in the economy. But for long-term investors, these valuations look interesting”. And, despite fears that last year’s Indian outperformance was due to a plethora of IPOs, now petered out, there are hopes that the country will deliver further gains, powered by the spending power of a growing middle class.

Such hopes are highly conditional: while there’s some indication that emerging markets’ reliance on western demand—and therefore western economic health—is weakening, it’s still a major factor: as the west slides into recession, this is likely to be amplified in emerging markets. There is a flipside to this, of course: when the global economy rebounds, emerging markets generally rebound harder, and will be a good place to be. While individual countries have shown their ability to break from the pack, as we’ve seen above, knowing which ones, when, and why is for most of us no better than a game of chance.

The difficulty of determining where the next round of outperformance is coming from militates in favour of the ongoing popularity of diversified emerging market funds in much the same way as we’ve seen diversified global equity funds gain traction with investors over recent years. That’s likely to persist, and for good reason. But it also indicates that, while the label has a utilitarian function, it pulls together a very different group of countries. For that reason, I think it unlikely that we’ll see an emerging market sub-theme such as Brics gain traction any time soon.

Emerging markets have traditionally come with greater volatility and, for those prepared to ride this out over the long term, a higher return. What’s more, their increasing importance in the world economy and the greater choice on offer should bode well. Emerging markets are also underrepresented in investment terms. They constitute 11% of the MSCI All Country World Index, but account for 34% of the world’s nominal GDP in US dollars and 46% in purchasing-power-parity terms, according to the IMF.

That, of course, is the long-term case. In the long term, as Keynes reminded us, we are all dead. And you can’t take it with you, though many historic EM leaders, from Emperor Qin Shi Huang to Pharoah Khufu, have certainly tried. In the nearer term, entry points need careful consideration.

Dewi John is head of research UK & Ireland at Refinitiv Lipper