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25 May 2017

The elastic band nature of emerging markets - and how to invest wisely

By Darius McDermott, managing director

When a local news outlet implicated Brazilian president Michael Temer in a bribery scandal last week, reactions were swift and predictable. Immediate calls for his resignation (refused); stock market and currency tumbles (8.8% and 7.1% respectively1); and protesting in the streets. After all, none of this is new to Brazilians; they know how to get a president impeached.

Is that where the country is headed this time round? Given the outlook on Brazil's politics, economy and fiscal agenda was just starting to look more positive than it had in several years, I hope not. But as always, emerging market investors need to be prepared for this kind of whiplash. Indeed, the higher risk profile is a key feature of the asset class - which is why it's so crucial to invest in a way that also gives you access to the most promising opportunities for long-term growth.

Markets stretched, some snap back inevitable

Since Temer stepped in after Dilma Rousseff was ejected from office last August, a wave of enthusiasm has overtaken investors that not even Trump's election could shake. In local currency, the Brazilian stock market had risen 16% between the day of Rousseff's impeachment and the day before the Temer tapes surfaced.

It is not just Temer himself whom investors have praised, but also his economic team and particularly his finance minister and the central bank president. Together, they were trying to tackle some of Brazil's most pressing economic problems, including high debt levels and a pension system it cannot afford. Market valuations had, arguably, become stretched recently on optimistic views around these pension reforms. The reforms will now inevitably be delayed and, if Temer is forcibly removed from office, quite probably abandoned.

And while central bank president Ilan Goldfajn has stressed that political turmoil will not directly impact policy decisions, it now seems less likely the bank will continue to lower interest rates (which it has been doing in a bid to boost growth) as inflation concerns may return. Only a couple of weeks ago, Brazil celebrated its lowest inflation rate since August 2010 at 4.08% - a remarkable improvement on its rate of inflation above 10% just over a year ago2.

At times like these, the benefits of investing in an active fund in emerging markets (as opposed to a passive fund like an ETF) become clear. Uncertainty and volatility may reign in Brazil for the mid-term at least - particularly as there is little clarity around who might replace Temer if he were impeached. But a good active manager can look for companies whose growth fundamentals rely on longer-term underlying trends that will ideally continue regardless of the macroeconomic environment. For a fund with quite a big weighting to Brazil, but exposure to other Latin American economies too, including Mexico and Chile, I like Aberdeen Latin American Equity.

Valuation concerns in India too?

Politically, India is certainly in a much more stable position than Brazil. So stable, in fact, that it has been one of the strongest performers globally since the start of the year. Prime minister Narendra Modi cemented his Bharatiya Janata Party's reform mandate with strong wins in several state elections earlier this year, and investors are hoping a pick-up in economic growth will translate to higher company earnings.

With this in mind, Indian equities have risen considerably. It is always an expensive market compared to most other emerging economies, but currently it is trading above its own long-term average too. I like India a lot and I'm very positive on its outlook as a global growth driver for the next couple of generations, but it is worth noting that there is quite a lot of positive sentiment priced in to its equities right now. If companies disappoint on earnings, or if certain sectors, such as state-owned banks, don't get the reforms they need, investors who buy in at these levels may need to wait quite a while to realise meaningful gains.

For those who are incurably interested, though, I'd suggest a fund such as Ashburton India Equity Opportunities, which is very concentrated in just 20 to 30 companies, meaning it can be quite different to the broader market.

Funds to diversify

In my view, diversification is a sensible way to approach emerging markets at the moment. Despite the challenges highlighted above, the growing populations, young workforces and substantial labour potential within these markets make them highly appealing for long-term investments.

Three global funds I like are:

  • Charlemagne Magna Emerging Markets Dividend - as of end April the fund has 9% weighting to Brazil and 11% to India, alongside a nicely balanced mix throughout China, Korea, Taiwan and Mexico, to name a few
  • M&G Global Emerging Markets - 11% in Brazil and 4.6% India as at end April, plus, again, an intriguing mix that includes small amounts in South Africa and Russia
  • Standard Life Investments Emerging Market Debt - another interesting way to gain exposure to the emerging markets theme could be through a bond fund. For those seeking broad access to these economies, this one may appeal with its decent chunks in Latin America, Africa and the Middle East, and Asia.

Where to next?

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius's views are his own and do not constitute financial advice.

1MSCI Brazil, TR in Brazilian real, 17/05/2017-18/05/2017. Currency change Brazilian real vs US dollar 2 Brazilian inflation falls to near 10-year low in April, Financial Times 10/05/2017

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