Emerging markets were overplayed, but not any more

Over the three-year period from 2011 to 2013 inclusive, emerging market equities – as measured by the MSCI Emerging Markets Index in GBP terms – returned -11.2 per cent. This significantly underperformed the FTSE 100, which returned 27.7 per cent.

Geopolitical issues in emerging markets have also come to the fore recently, with the likes of the conflict between Ukraine and Russia, the resurfacing of troubles in Iraq, and protests in Brazil all making headline news.

With this backdrop, it is natural for investors to start questioning whether they should reverse their earlier forays into emerging market countries. The first quarter of 2014 alone saw almost $50bn (£31bn) of fund outflows (according to EPFR Global and HSBC calculations). 

So has the shift from developed to emerging/frontier markets been overplayed? We believe it was, but not any more. There are three reasons why we are increasingly positive about investing in emerging markets.

Quality not quantity

A lot of attention has been placed on diminishing levels of economic growth in countries such as China and India. However, it is much more relevant to focus on the quality of growth rather than just the quantity.

High economic growth does not necessarily relate to high investment terms. For example, £100 invested in China A shares in 1992 would only have been worth £107 at the end of 2013, despite 20 years of 10 per cent economic growth each year.

In our view, an improvement in the quality of growth – aspects such as the rise of middle classes, economic reforms and development of local capital markets – is more likely to be a key determinant of future returns than the speed of growth.

We have seen positive signs, such as the onset of significant reforms in China, Mexico and India, that support our quality-of-growth argument, which could enhance future returns in these regions.

Divergence in prospects

As we begin the slow move away from low interest rates in developed markets, increasingly there is significant variation in the prospects of different emerging market countries.

For example, a country such as Brazil is vulnerable in our view, with a stuttering economy, high inflation and an over-reliance on commodities production all causing concern.

In contrast, India has improving economic data, signs of reducing inflation and significant reform potential following recent government change, leading us to be optimistic about its prospects.

For multi-asset managers with the flexibility to choose what to buy and what to avoid across global markets and different asset classes, this divergence is exciting.

Valuations

Last but not least, the corrective price action seen over much of 2013 and early into 2014 has resulted, in many cases, in more attractive entry points and supportive long-term valuations across equities, bonds and currencies. It should be noted though that in certain cases assets are cheap for a reason, and reflect inherent investment risks (eg Russian equities).      

When investing in emerging markets, it is important to remember a few key points. First, an undiscriminating approach is fraught with danger: non-selection is as important as selection.

Second, do not be greedy: do not buy investments solely because they are cheap, and exit positions when they reach their target.

Finally, size appropriately: emerging markets can be risky, so allocate accordingly. 

We believe emerging markets cannot be ignored; they account for 75 per cent of the world’s population and 55 per cent of the world’s gross domestic product. So get back on that bandwagon – but choose your targets very carefully. 

Atul Shinh is a multi-asset investment specialist at Investec Asset Management