Opinion

Emerging markets – sounder economies, but are they always sound investments?

By Greg Fleming
Head of Investment Strategy New Zealand

There has been a fair quantity of media coverage about emerging markets in recent months, much of it prompted by the worries over global trade arrangements that accompanied the Trump electoral victory in the USA six months ago. The US withdrawal from the Trans Pacific Partnership ratification process has caused some consternation in those developing economies aiming to increase their exports to the US consumer. On the other hand, the stay-of-execution that the Trump Administration has extended to NAFTA (North American Free Trade Agreement) reassured observers that a swing to protectionism is likely to be erratic. The US Commerce Secretary, Wilbur Ross, is still to present his report on the causes of the huge and persistent US trade deficit and how they might be combatted.

In the meantime, emerging markets have benefited from the synchronized global economic upswing, some stabilisation and recovery in commodity prices, and better conditions in China. At the beginning of May, the 2017 year-to-date performance of emerging market (EM) equities had already reached 14% – that is, 50 percent more than their full-year expected annual return, logged in the first four months of this year.

This stellar performance followed the 11.4% local currency return emerging markets had achieved in the fourth quarter of 2016 – almost double the return from global equities over the same period. Recently, the emerging equity market return has diverged markedly from commodity prices, which have been trending sideways for the last six months while share markets rallied.

Emerging market equity returns have recently outstripped commodities

Source: Bloomberg

As often occurs in investments, assets with the strongest recent performance then become the ‘darlings’ of market commentators. Encouraged by ease of access through exchange-traded-funds (ETFs), retail investors around the world have allocated funds ever-more adventurously into the emerging markets in recent months. Not only have the volatile, but potentially rewarding EM equity markets attracted inflows, ETFs have made it comparatively easy for non-professional investors to acquire exposure to emerging market sovereign and corporate bonds.

The global search for investment yield, which has been such a persistent feature of our current low-interest-rate environment, has encouraged investors with a strong stomach for volatility to flood into assets with comparatively high income streams attached. For instance, the running yield on the main diversified EM bond index tracked by ETFs (JP Morgan’s EMBI Global Core Index) is currently over 4.5%, and total returns over one year are over 8.0%. Some dividend-focused EM equity ETFs have recorded total returns in the region of 25% over the last year (to 31 March.) Some investors have found these reported return levels too tempting to ignore.

The media focus on the doings of Donald Trump, and on the European political populists, may have flattered some EM governments by comparison and lulled investors into giving them “the benefit of the doubt”. However, it is difficult to build exposure to the EMs in a portfolio without buying significant stakes in economies governed by different norms to our own. Russia, Brazil, China and India all present forms of political risk. An example has just been furnished by the widening corruption and bribery scandal surrounding caretaker President Temer of Brazil, which has hit local assets hard last week.

Brazil shows that political risk in emerging markets can be potent and hit quickly.

Source: Bloomberg

While the sharp fall (-9% in local currency) in the Brazilian index on Thursday only returns the market value to where it was at the beginning of this year, it serves as a timely reminder that political stability cannot be taken for granted.

One popular ETF used to track the Brazilian market declined 18% (in USD and NZD terms) on the same day. A move this size was last seen in October 2008, during the Lehman crisis. Though a small rebound followed on Friday, it may not last as the Senate voted over the weekend to proceed with an impeachment trial. The precipitous drop reflected both the fall in the stock market and the simultaneous sharp weakening in the Brazilian Real.

The proliferation of ETFs traded online, often from home, has made it very simple for investors to express fear, and to rush for the exits en masse. Brazil is only one (very large) country, representing around 7%-8% of EM equity indices. A commonly-used globally-diversified equity ETF thus only declined by 3.5% on the same day as Brazil was hit by panic-selling.

Finally, bear in mind that when agile global investors decide to exit a vulnerable market, it is common to sell the currency alongside selling out of their holdings of equity or bond securities. This can aggravate losses.

Implications
On the positive side, emerging economies often offer unique exposures to resources and reforms with dividends not available in the developed world.

When deployed moderately, EMs can boost portfolio returns, but it is vital to know when to reallocate between individual markets, how to mitigate the risks of passive exposure, and how to minimize currency risk. Above all, being prepared for sharp market moves and retaining an acute awareness of the power of sentiment can prevent disappointment.

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Important notes

This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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