One of the biggest talking points amongst investors in 2019 seems to be emerging markets. At the end of 2018, besides my exposure to South African equities via my Retirement Annuity, I had virtually no emerging market equities in my portfolio (I did have some exposure to EM bond funds). So I set about investigating whether the time was right to diversify into these markets in 2019.
After generating extraordinary returns in 2017, emerging markets equities fell significantly in 2018 as macroeconomic and geopolitical developments weighed on market sentiment. The MSCI EM Index declined 14.6% in 2018 and 7.5% in the fourth quarter.
According to Lazard Asset Management, some of this performance reflected the fact that emerging markets generated extraordinary returns in 2017 and that the asset class is relatively volatile.
Lazard says that in 2018, fear came back to emerging markets investors. “In 2019, we believe the uncertainty and volatility will persist, but we also expect clarity on a number of issues. In our view, if these issues resolve favourably—e.g., a stable or declining US dollar, a workable trade scenario, accelerating growth outside the United States—then emerging markets will likely benefit.”
At the same time, it says it is important to note that equity declines in 2018 have significantly lowered valuations. At the end of the year, the MSCI EM Index was down to 11.8x trailing earnings, from 15.0x times, a discount of about 35% compared to US equities. This discount is wider than the average, which has historically hovered around 20%.
In addition, this discount offers exposure to potentially greater growth opportunities—8.0% EPS growth vs. 7.6% for the United States in 2019—as well as relatively attractive free cash flow yields (6.5% versus 4.8% in developed markets and 4.3% in the United States). Emerging markets equities also offer opportunities to pick up dividends for yield-hungry investors—the emerging markets dividend yield is about 2.9% compared to 2.1% for the S&P 500 Index.
“Investors can hold emerging markets for tactical reasons, but we believe the emerging markets “story”—characterized by higher growth potential, stabilizing institutions, a rising middle class of consumers—remains valid, regardless of higher volatility and relatively short-term changes in investor confidence. We believe that emerging markets companies with strong prospects, effective management, and relatively attractive prices remain one of the best ways to access this long-term investment opportunity,” says Lazard.
According to Keith Wade, Chief Economist & Strategist at global asset manager Schroders, in 2019, the volume of money in the global financial system is expected to reduce. “The main reason for this is a change in the activities of major central banks. After a period of buying government bonds, the US Federal Reserve (Fed) plans to sell back some of these investments, withdrawing some cash in circulation. The European Central Bank has said it will stop buying bonds. This leaves the Bank of Japan as the only major central bank still contributing to new money to the financial system (through the purchase of its government bonds),” says Wade.
He explains that this is important, because cheap, easy money encourages investors to take greater investment risks. “In recent years this has helped direct investment into peripheral eurozone markets (e.g. Greece, Portugal, Spain and Italy), some emerging markets and also lower grade corporate credit. As liquidity is withdrawn from the system, important support for these markets disappears. The early effects of this trend were already being seen in emerging markets in 2018. In 2019 they look set to intensify,” says Wade.
Wade adds that given the above discussion it may seem odd, he believes that emerging markets can make a comeback in 2019. This is, however, one condition that the US Fed’s policy of interest rate rises comes to a halt. “Should this happen – and we forecast one more rate rise in June, taking US rates to 2.50-2.75% – there is a good reason to believe the US dollar will lose some of its strength. This would provide a welcome relief to those investors that borrow in dollars –a heavyweight of whom resides in the emerging markets,” says Wade.
He explains that the positive effects from this development could more than offset the pressure from the withdrawal of money in the global financial system and escalating trade tensions. “Arguably, prices for emerging market assets may already be discounting the worst, with both equities and foreign exchange in those countries having fallen significantly, so there is room, following some good news, for a bounce,” says Wade.
The sentiments expressed by both Schroders and Lazard seem to be shared by most of the large asset management houses.
I tend to agree with them so in early January, after consulting with my financial advisor, I invested roughly 5% of my overall offshore portfolio in the Vanguard FTSE Emerging Markets UCITS ETF.
This Fund seeks to track the performance of the FTSE Emerging Index, a free float market capitalisation weighted index of large and mid-cap companies in multiple emerging markets in Europe, Asia, Africa, Central and South America and the Middle East. The Fund employs a “passive management” – or indexing – investment approach, through physical acquisition of securities, designed to track the performance of the Index.
The fund has about 65% of its investments in Asia, which suits me just fine as lets face it, that’s the future of the world’s economy. The rest is in Latin America (15%), Africa (8%) and emerging markets in Europe (6%). Best of all, because its an ETF, the fees are low at .25%
The investment was taken from the cash portion of my portfolio, so I didn’t disinvest from any other equity or bond funds to make this investment. It did have the effect of slightly increasing my exposure to equities to around 45% of my offshore portfolio, but I am comfortable with that, given my age and income needs.
So far the fund is up 3.5% this year so that’s pleasing. But as always, this is a long term play for me so the intention is to hold it for several years.
*Information in this article should not be used as financial advice or to make financial decisions. Please speak to an accredited financial adviser to assist with any investing decisions.