Emerging markets have given up ground in the third quarter, so this week I look at the reasons behind the recent sell-off and consider whether the investment case remains valid.
A number of events have conspired to bring about the loss of confidence. The first is the ongoing strength of the dollar (partly due to rising interest rates) which makes any debt in US dollars more expensive.
The second event has been currency crises in a number of weaker economies, notably Turkey and Argentina. Countries worst affected were those with large current account deficits and foreign debt. This led to investor flight which put stock markets under pressure. Turkey dragged its feet before reluctantly lifting rates to 24% while Argentina had to request an IMF bail out, accompanied by the promise of austerity programmes.
A third concern has been the fallout from US-Chinese trade wars. The introduction of further tariffs has knock-on effects for other countries in Asia that rely on trade with China.
Finally, oil prices have risen to a 4-year high driven by continued global growth and ahead of US sanctions on Iran. This has negatively impacted countries dependent on oil imports. There should be winners too, such as Russia, although the country is also facing sanctions from the US.
All of these factors contribute to higher inflation. If excessive, it will lead to interest rate rises, and in turn, this can subdue economic growth. In India, for example, the rupee has fallen heavily this year, pushing up the price of imports including oil. This situation, plus a large conglomerate defaulting on its debt, unnerved the stock market despite the underlying economy performing well.
Should we keep faith with Emerging Markets?
To put things into context, in the three months between June and August, the MSCI Emerging Markets index has fallen 1.4% in sterling terms, compared with a 6.3% rise for the MSCI World index. It’s impossible to know how far-reaching any trade wars will be, but we have seen before that Trump’s bark can be worst than his bite and a lot of his blustering is done to provoke a reaction. Thus, such contagion fears could dissipate quickly.
US interest rates are clearly rising, but far more debt is now held in local currency than in the past which should mitigate some of the concerns about default risks. What’s more, the leading economies of India and China both offer reasons to be positive.
China is making a relatively successful transition from ‘old economy’, such as heavy manufacturing and mining, to new economy sectors such as technology and financial services. The central bank may decide on further stimulus to halt any slowdown in the economy and there are early signs that infrastructure spending is recovering.
India’s reform agenda has laid the foundations for a modern and efficient economy with a stable financial system. So far, the economy has held up well and remains one of the fastest growing, though an eye needs to be kept on inflation.
Any downturn in global trade makes it harder for emerging markets to out-perform but the current IMF GDP growth forecasts, of 6%+ for China and 7%+ for India, remain impressive compared to developed markets. Moreover, emerging market valuations remain cheap on a valuation basis relative to global equities. To some extent, this is a reflection of the higher inherent risk and an ‘old economy’ bias but should be weighed against favourable demographics driving domestic demand.
Political risk is always present in emerging markets. In Brazil, the most ‘market friendly’ election candidate is lagging the extreme right and left-wing parties. The latter are unlikely to implement the policies needed to tackle the budget deficit and revive an economy hit by strikes. Russia faces ongoing tensions with the US where congress is considering further sanctions for alleged electoral interference.
Certainly, the region is not homogenous and there is a need to be selective about areas invested in. Emerging markets are not for the faint hearted but in my view, you can’t tar all countries (there are 24 in the index) with the same brush. Fortunately, the real problem children, Argentina, Turkey and South Africa, are small components of the index.
There may well be further dips but often it’s when sentiment is at its worst that the best buying opportunities arise. Careful stock picking is essential and that is where skilled Fund Managers are worth their salt. My preference would be to stick to funds with an Asia focus, rather than Emerging Europe and Latin America. This could be an emerging market fund with a focus on Asia, or a dedicated Asia fund (which will have exposure to developed Asia, such as Hong Kong and Singapore).
First State Stewart has a well-resourced team covering Asia. Managers adopt a bottom-up, high conviction approach, focusing on high quality companies with good growth prospects. Funds include the Stewart Investors Asia Pacific Leaders, Stewart Investors Global Emerging Markets Leaders and Stewart Investors Global Emerging Markets Sustainability. All provide significant (over 20%) exposure to India and the third one may appeal to those attracted to a responsible strategy during Good Money week.
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