Emerging Markets: Stay in the Car

Investing in emerging markets has been a bumpy ride for the past several years. Some investors may be considering whether they should avoid these markets altogether because of their recent underperformance versus developed markets. We believe there are plenty of attractive reasons for staying invested in emerging markets over the long term.

When we look at emerging markets, we focus on the underlying fundamentals of the investment. We consider both the broader macro economy and the corporate environment within our assessment. In our view, current conditions suggest potential improvements for emerging markets.

Over the past five years, emerging markets have significantly underperformed developed markets by about 60%, but if you’ve been in emerging markets for ten years, outperformance has been at about 40%. Looking at markets on a long-term basis, this decade-long period may be the right time frame.

Emerging markets underperformed developed markets by 8% in 2014 with a negative absolute return of 2% in U.S. dollars. But this still made emerging markets the second best performing asset class, doing better than Japan, Europe or the UK. If you calculated returns in Euros, Yen or Sterling, you made a positive absolute return.

In short, perspective is important.

There remains a potentially brighter future for emerging markets, with improvements in macroeconomic and corporate conditions likely to pay off in better stock market returns. Temporary travails in emerging equities often do not reflect fundamentals. People quite often take the view that stock market performance in the short term reflects underlying issues in that market, but this may not be the case in emerging markets.

This disconnect existed because emerging stock markets are often led by foreign investors. Domestic institutional and retail investors are not consistent players in the market, so the guys who drive emerging markets are typically foreigners. This is an important element because foreigners sometimes get concerned about different things from what’s actually occurring on the ground. For example, what’s happening with quantitative easing, and the impact of the European Central Bank (ECB) and Bank of Japan, can have a large impact on liquidity flows into emerging markets, and a disproportionate impact on the performance of these markets.

Moreover, because emerging stock markets are, in most cases, less liquid, it may not take much to send them up or down. To put it in some sort of context, over the past three out of four years they’ve seen negative outflows. So there’s been a lot of money going out of emerging markets. Or has there? Actually it’s not a lot of money. For 2014, we’re talking about $25 billion. That’s a rounding error on the U.S. Federal Reserve’s (Fed) balance sheet.

If investors ignored short-term negative sentiment that had nothing to do with emerging market companies  themselves, they could be rewarded by improving fundamentals. Worries about U.S. monetary tightening had hit emerging equities, by stoking fears that emerging economies’ current account deficits, hitherto financed by the large global supply of dollars, would no longer be sustainable.

However, by raising interest rates, emerging economies had reined in these deficits. For example, India’s central bank predicts that the country’s deficit will shrink to 1.3% of GDP this fiscal year, down from a record high of 4.8% in 2012-13. The reduction in deficits left emerging markets much less vulnerable to further signs of U.S. monetary tightening.

The sharp decline in the price of oil is also largely a beneficiary for emerging markets, with almost 75% of emerging economies net oil importers. The potential benefits include improved fiscal position via reduced oil subsidies, narrowing current account deficits as oil import bill comes down, falling inflation which should lead ultimately to lower interest rates, and accelerating economic growth as a result.

Emerging market companies had responded well to tough times. They have been cutting costs and doing the right things. That will eventually lead to better profitability. Given the large discount these companies trade at relative to the recent past and to regional peers, things don’t look too bad.