Stars align for emerging markets

With China’s weighting in the Morgan Stanley Capital International or MSCI EM index at 43 per cent, Taiwan 13 per cent, South Korea 12 per cent and India 8 per cent, the big four Asian markets now constitute 75 per cent of the index. Picture: iStock

Against a backdrop of the US election and the announcement of a potential coronavirus vaccine, we have seen continuing volatility in equity markets, with “risk on” — or increasing risk — being the theme.

While interest rates continue to be low and governments provide stimulus to the global economy, the medium-term outlook for equities and other risk-based assets seems underpinned for now.

So where are the opportunities?

For me, a key area is emerging markets equities.

Damien Hennessy at Heuristic Investment Services says EM look cheap on a relative basis to developed market (DM) equities. Here’s why.

● Valuations are neutral to low — close to where they were coming out of the global financial crisis, with a forward price-earnings ratio of 14.7 times or a 25 per cent discount to DM equities at 19.9 times earnings, against the average historical discount being 20 per cent.

● Policy settings are positive — interest rates globally are at record lows and the outlook on any tightening will be macroprudential-oriented as opposed to the usage of monetary policy. Hence the continuation of a weaker US dollar (down 7 per cent since April) is on the horizon — traditionally a positive for EM with cash rates above that of DMs.

● The macro is positive — relative growth on the back of China in particular is a positive. Chinese GDP in the past two quarters has been up 11.7 per cent and 2.7 per cent, after having fallen 10 per cent in the March quarter.

● The price momentum for EM Asia is positive — the region is viewed having dealt with COVID-19 very well, especially relative to the US and Europe.

Do keep in mind, however, that “emerging markets” is a misleading term. With China’s weighting in the Morgan Stanley Capital International or MSCI EM index at 43 per cent, Taiwan 13 per cent, South Korea 12 per cent and India 8 per cent, the big four Asian markets now constitute 75 per cent of the index.

What’s more, EM can be a bucket for everything else with the index comprising 26 different markets. That means the remaining 22 markets make up 25 per cent, led by Brazil.

Given the index and an estimated 70 per cent of global growth over the next 20 years is expected to come from Asia, it is vital to choose wisely in regard to how you gain exposure.

Aim to ensure exposure to both the markets and, more importantly, to strong “bottom-up” stock selection. This gives exposure to growth in this asset class.

After all, that’s why you are seeking this kind of exposure, versus the route of country selection that can expose you to unsatisfactory risk levels.

Looking at the investment environment more broadly, the noise from both the US election and vaccine will die down and the focus will return to the marked increase in COVID numbers.

There are worrying COVID spikes in the northern hemisphere, where parts of the US and Europe are now seeing record infection rates and new lockdowns are being imposed. In Britain, London has just gone back into lockdown.

What this boils down to is ongoing market volatility. I remain confident that while we are not staring at a double-dip recession I am concerned that the impact of the recession could be with us for longer than many foresee.

That said, there are positives:

US election uptick: The US election result does not appear harmful to markets, and a key uncertainty of the election in the first place that has been hanging over markets will be removed.

Stimulus: More US economic stimulus is coming at a fiscal level and the Federal Reserve continues to pump liquidity into the system.

Low rates: The Reserve Bank of Australia cut interest rates from the already historically low level of 0.25 per cent to 0.1 per cent. A move to zero could be next.

These three factors auger well for risk-based assets.

In approaching risk-based assets, I look for asset classes or sectors that stand out.

Very hard to find at the moment, but EM makes a compelling case.

I believe investors can approach this asset class with an overweight position.

Will Hamilton is the managing partner of Hamilton Wealth Partners.

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