Is it the time to buy emerging markets?

Google the question “Is it time to buy emerging markets (EM) in 2019?” and a cavalcade of experts appear to be espousing EM. Do the same for 2018 and you find another herd of EM bulls.

Those who followed that advice in 2018 were burned as markets fretted about China’s slowing growth and the escalating US-China trade war. The MSCI Emerging Markets Index – the key barometer for EM equities – shed almost 15% in 2018 in US-dollar terms.

There is reason to be more optimistic on EM this year, but taking a short-term view is speculation. And basing that view solely on hard-to-predict factors – for example, US dollar strength or the outlook for Chinese economic growth – is a wealth destroyer.

Care is needed with simplistic calls to buy EM; the relationship between the US dollar and China’s growth, regarding EM, is not as clear cut as it seems for Australian investors.

In theory, higher US interest rates support a higher US dollar, which is bad for EM in two main ways. First, a reversal of capital flows as more money returns to the US and away from EM countries that rely on foreign capital inflows to fund their deficits. Second, a higher US dollar makes it harder for EM countries to service US dollar-denominated debt, so foreign investors become more risk averse to EM equities.

The reverse holds true: a lower US dollar should be good for EM equities and is a key reason why commentators are recommending them. After gains in the US dollar index (which is an average weighted index of a basket of currencies), analysts expect a lower US dollar.

That has implications for Australian investors who buy EM equities through an exchange-traded fund (ETF) in unhedged currency. A rising Australian dollar relative to the US dollar weighs on the performance of their ASX-quoted investment.

Higher official economic growth in China, apart from being less reliable, is also good for EM equities. But it suggests higher global growth and commodity prices, and a higher Australian dollar. Again, that affects local investors who are invested in an EM ETF in unhedged currency.

My point is: that trying to second-guess changes in currencies or Chinese growth is a mug’s game. So too is relying on simplistic correlations or trends to buy or sell EM equities.

Far better is a long-term, asset-allocation approach to EM that understand the role of EM in portfolios, the need to rebalance allocations and what matters most: valuations.

Understanding emerging markets

The term “emerging markets” is somewhat of a misnomer, in my view. One my favourite recent books, Factfulness by Hans Rosling, exposed the myth about developed and developing markets. As Rosling noted, only 13 countries today, or 6% of the world’s population, are developing nations. The gap between developed and emerging is not as big as many think.

The MSCI Emerging Markets Index is full of billion-dollar companies such as Samsung Electronics, Tencent Holdings and Alibaba. EM is still a risky asset but its risk profile has changed as Asian countries rapidly industrialise and giant companies emerge.

As to asset allocation, a growth portfolio (five to 10 years to retirement) should have no more than 5% in emerging markets. A balanced portfolio (within five years to retirement) might have up to 3% exposure, and a conservative portfolio (in retirement) should have none.

Emerging markets exposure is important for growth portfolios because EM has a history of outperforming developed market equities over long periods. The chart below from MSCI’s April 2019 report, The Future of Emerging Markets, shows the outperformance (in US dollar terms).

Source: MSCI

The reasons for outperformance are obvious: emerging markets have faster growth prospects than developed markets, albeit with higher volatility.

As such, prospective investors in EM should have a horizon of at least seven years, preferably longer, so they can weather short-term volatility. That is why EM suits growth investors who are at least five to 10 years from retirement and can recover from near-term losses.

Longer term, my interest in EM is based on the boom in middle-class consumption in these markets – among the greatest trends in human history. Another two billion people in emerging markets will join the middle-class by 2030, on OECD forecasts.

Self-managed superannuation funds (SMSFs) that want exposure to this megatrend need EM exposure in their portfolios and a willingness to maintain it for years.

Moreover, growth portfolios need to rebalance their EM asset allocation (as with any portfolio asset) periodically to ensure they stick to that 5% target. That involves reducing EM exposure when the asset rallies and adding more when it falls.

Aggregate valuations

So, how do you know when to rebalance an EM allocation? Focus on aggregate valuations in key indices and compare them to their historical norm.

The two metrics I use are aggregate price-to-book ratios and the aggregate price-earnings (PE) trailing ratio over 12 months.

The first shows how share prices compare to asset value and the second shows how prices related to historic earnings. In Australia, I look at a forward PE based on a company’s forecast earnings, but such forecasts are less reliable in emerging markets.

Emerging markets historically trade on an average price-to-book discount of 20% compared to developed markets. At the end of January 2019 that discount was 30%, according to MSCI data, suggesting EM were historically cheap on this valuation metric.

The aggregate PE discount between EM and developed markets was broadly in line with its historical average, found MSCI. On an absolute basis, the aggregate PE for the MSCI Emerging Markets Index (13) compares to almost 18 for the MSCI World Index.

The chart below shows how these valuation metrics have trended. Look at the valuation gap between developed and emerging markets equities from 2014 to 2018.

Source: MSCI

Simply, EM equities look attractive on key valuation metrics, relative to historic norms. They are not a screaming buy, but there is enough to suggest that EM gains can continue and, more importantly, that now is a reasonable entry point for long-term investors.

Gaining exposure

For short-term and medium-term investors there is a good case to use active fund managers who can trade EM and protect capital during bouts of high volatility. If you have a long-term portfolio with a seven-year-plus outlook, I would use an ETF.

Ideally, I would use a currency-hedged ETF for emerging markets exposure but none are quoted on ASX (most ETFs are unhedged). So returns will be influenced by the Australian dollar in addition to the underlying asset.

The iShares MSCI Emerging Markets ETF (ASX:IEM)is the best known of its kind in this market. It aims to track the MSCI Emerging Markets Index and holds 1,136 stock constituents. The ETF offers good country and sector diversification: about a third of its holdings are China-based. The median company size in the index is about US$2 billion.

The ETF had a five-year annualised return of 9% to March 31, 2019. There was significant return volatility within that and strong gains in 2017 boosted the average. A fee of 69 basis points is a lot less that most EM actively managed funds.

An attraction of ETFs is their use in portfolio rebalancing. Bought and sold like a share on ASX, long-term investors can easily rebalance their EM asset via an ETF – and take a long-term asset allocation approach, which beats relying on Google and market noise to form an opinion.

Chart: iShares MSCI Emerging Markets ETF performance

Source: BlackRock 

Here is a list of other ETFs that provide broad EM exposure that investors can also consider:

• WEMG:ASX – SPDR S&P Emerging Markets ETF (Passive)
• VGE:ASX – Vanguard FTSE Emerging Markets ETF (Passive)
• FEMX:ASX – Fidelity Global Emerging Markets ETF (Active)