The time is right to invest in emerging markets

Stanley Yeo – IOOF Deputy Chief Investment Officer

Investing in emerging markets is not for the faint hearted. When people get nervous about equities, they tend to sell out of emerging markets and vice versa. Unexpected political problems, such as corruption or weak economic growth, can also quickly derail a market. However, there are many reasons and strong structural trends supporting emerging market equities.

The emerging markets account for approximately 80 per cent of the world’s population, almost 60 per cent of the world’s economy and the emerging market middle class is growing rapidly. EM growth is very likely to significantly outpace that of developed economies. If forecasts by the International Monetary Fund turn out to be accurate, emerging market GDP will be over 27 per cent larger by 2021 while developed market GDP will only have increased by 9 per cent.

From a cyclical perspective, emerging markets look attractive as emerging market stocks offer relatively cheap valuations and strong growth rates for earnings. For five years, the asset class suffered from a multitude of hardships, among them a fall in oil and other commodity prices, the slowdown in China, political turmoil in nations such as Brazil and Turkey, and sanctions imposed on Russia.

From early 2011 to early 2016, the SCI Emerging Market Index dropped over 40 per cent. Valuations fell to levels not witnessed since the Asian currency crisis of the late 1990s. However, starting in mid-January of last year, buoyed in part by a resurgence in mining and petroleum, emerging markets have rebounded strongly. Despite the jump, emerging market shares remain cheap – keep in mind that as at 30 June 2016 they are still 21 per cent cheaper than in 2011.

Today, the Shiller Cyclically Adjusted Price-to-Earnings multiple (CAPE) for the MSCI Emerging Markets Index is 15.6, up from around 10 at the trough in early 2016. However, it is still 44 per cent below the reading of 28 for the US, its highest level since the tech bubble in 2001. The CAPE eliminates sharp, temporary swings in earnings that can make shares look artificially inexpensive or pricey by using a 10-year average of inflation-adjusted profits. The last time emerging market equities traded this cheaply relative to the developed world, they outperformed the S&P500 Index significantly over the next 12 years.

Emerging market growth reached a low in 2016 and has exceeded expectations since. In China, massive policy support helped drive increases in demand for goods and services. China’s recovery also boosted demand globally for commodities, providing a tailwind and a path out of recession for Russia and Brazil. India’s economy has also bottomed following the decline in activity resulting from the government’s move to demonetise and replace its largest bank notes.

Along with Brazil, Russia, India and China, many other emerging economies, including South Africa and Indonesia, have experienced significant improvements in current account balances over the past three years. Furthermore, projected appreciation in emerging market currencies is another reason why emerging market shares are attractive. The Mexican peso, Chinese yuan and Indian rupee are still more than 15 per cent undervalued versus the dollar, based on relative purchasing power.

While emerging market investors will always experience ups and downs, the main reason to invest in the region is to increase diversification and capture better growth prospects in the long term.

As we believe the time is right to invest in emerging market, the IOOF MultiMix and IOOF MultiSeries Trusts have 26 per cent and 14 per cent of its international equities exposure to specialist emerging market managers, respectively. This represents an overweight position versus benchmark of 15 per cent for IOOF MultiMix and 2 per cent for IOOF MultiSeries.

Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.