Can emerging markets sustain last year’s rally?

Harvey Jones asks the experts if the rally will continue this year

Emerging markets (EM) roared back to form in 2017 to reward investors who stuck by them through the last disappointing decade. China and Asia-Pacific region led the charge, surprising those who had written off the region after years of erratic performance.

The question now is whether they can continue their run in 2018, and whether there is still time for investors to join in the fun. So far, the answer to both questions seems to be yes, unless we get a major shock, such as a full-blown conflict with North Korea, or US president Donald Trump launching a trade war with China.

Bumper year

Emerging markets have just posted their best year since 2009, growing a meaty 37.72 per cent in 2017, according to MSCI, well ahead of the rest of the world, which grew 14.4 per cent. China had an astonishing year, its stock market grew 52.5 per cent, while India grew 30.49 per cent, South Africa 36.12 per cent and Brazil 24.11 per cent. Of the emerging giants only Russia disappointed, rising just 0.08 per cent.

Separate research from Fidelity International shows EM were last year’s best performing asset class, racing ahead of Europe, Japan, the United Kingdom and United States in what was a strong all-round year for global stock markets.

The Asia-Pacific region, which includes emerging countries such as China, India, India, Taiwan, Thailand, Hong Kong, Philippines, Malaysia and Singapore, was the second-best performer.

Tom Stevenson, investment director for Fidelity, says Asia and EM should continue to fly in 2018. “The long-term regional growth story remains intact and stock market valuations are still reasonable despite recent successes.”

Before tipping your money into EM however, it is important to remember that past performance is never a reliable guide to future returns. Last year’s winner is often next year’s loser. Also, check what exposure you already have to countries such as China and India; you may have more than you realise after the last rip-roaring year, Mr Stevenson says.

Remember the Brics?

Jim O’Neill, then chairman at Goldman Sachs, coined the term Brics back in 2001 to describe emerging giants Brazil, Russia, India and China. The original quartet has since been joined by South Africa.

These five countries cover a quarter of the world’s landmass, have a combined population of around 3.6 billion, produce half the world’s workforce and account for around a quarter of global GDP.

Their economies and stock markets flew in the run-up to the financial crisis, with China repeatedly posting double-digit annual economic growth to become the world’s second-biggest economy, but they could not escape the developed world’s meltdown.

The Brics fell like a ton of bricks in 2008, losing a massive 49.74 per cent of their value, with further sharp falls both in 2011 and 2015. They sparked global panic in January 2016 amid fears over credit and property bubbles in China, but the only way has been up since then and investors are flooding back into the sector.

HSBC’s EM strategy team recently issued a 20-page report saying it expected the flood to continue in 2018, amid solid Chinese growth, greater stability in Brazil, and stronger commodity prices, still the chief export for many emerging economies. They should also benefit from the robust global economy, with Europe in particular growing strongly.

Resilience

Vijay Valecha, chief market analyst at Century Financial Brokers in Dubai, says the 2017 recovery was driven by greater confidence in the region’s resilience to economic shocks, with Hong Kong and India doing particularly well. “The Hong Kong 50 rose by 45.2 per cent in 2017, India’s Nifty 50 climbed 33.5 per cent,” says Mr Valecha.

Chinese stocks such as retail major Alibaba, internet enterprise Tencent, web services company Baidu and online retailer JD have strong growth fundamentals and support from analysts, he says, and are attracting foreign investors.

Mr Valecha retains a bullish outlook for 2018 as EM play catch-up with a slowing US. “Countries like Brazil and Russia have ample scope to cut interest rates, even as the US Federal Reserve continues to tighten. In India and East Asia, newly minted middle-class consumers are helping companies generate big gains, particularly the banking sector.”

Mr Valecha says the best way for ordinary investors to tap into these markets is through an exchange-traded fund, a low-cost passive investment vehicle that tracks the performance of a range of global markets. ETFs also spread your risk and offer diversification by investing in hundreds of different companies, he says. “Investing in international stocks, especially emerging markets, requires deep understanding of that particular country’s economics. ETFs eliminate most of the hard work because each fund includes a wide variety of holdings that focus on a specific theme.”

Mr Valecha tips iShares MSCI Emerging Markets ETF as a good general emerging markets fund. The US$42 billion fund, listed in New York and like most ETFs available on global share dealing websites, grew 36.42 per cent last year. Roughly 30 per cent of the fund is invested in China, 15 per cent in South Korea, 11 per cent in Taiwan, with further exposure to India, Brazil, South Africa, Russia, Mexico, Thailand, Malaysia, Indonesia and Poland. For more focused exposure to EM Mr Valecha recommends either Vanguard FTSE Pacific ETF, Morgan Stanley India Investment Fund or PowerShares Golden Dragon China Portfolio.

Room for growth

Edward Evans, a money manager at Ashmore, says last year’s EM rally was mostly driven by fast rising corporate earnings, which means equity valuations are far from over-stretched. “This gives the potential for another strong, albeit likely more modest, year of returns.”

He says the region should benefit from the “ongoing synchronised pickup in global growth” as it catches up with the developed world.

This echoes IMF forecasts,

which predict the global economy to grow 3.7 per cent in 2018 with EM rising notably faster at 4.9 per cent, up from 4.6 per cent in 2017. It forecasts China will climb 6.5 per cent and India by a whopping 7.4 per cent. By contrast, the US is expected to grow 2.3 per cent and the UK 1.5 per cent.

However, risks remain, with the IMF warning that China must accelerate efforts to curb its credit bubble while India’s transition from a cash-based society to digital banking is proving disruptive. It also warned that Russia remains too dependent on high oil prices, while both Brazil and South Africa are hampered by corruption and political scandals.

Mr Evans anticipates further growth but warns that China may slow as the authorities focus on the quality of economic growth, while centralising control to reduce risk. He says tax reforms and fiscal stimulus should boost India, while Brazil and Russia should continue their revival. “Politics may be a source of market volatility, especially in Brazil’s case given uncertain 2019 elections, but this looks unlikely to derail the ongoing economic recovery,” says Mr Evans, who sees a virtuous circle forming in emerging markets.

The US dollar factor

A key factor for EM is the strength of the US dollar; with a strong dollar causing two problems. First, commodity exports such as oil, gas, copper, iron ore and other metals and minerals are priced in dollars, and this makes them more expensive to buy, hurting demand.

Second, EM have borrowed heavily since the financial crisis and as this debt is largely denominated in dollars, a strong dollar makes those liabilities even larger.

Emerging markets benefited from last year’s weaker dollar and the same could happen this year, says Christopher Dembik, head of macro analysis Saxo Bank. “Emerging market stock valuations still look extremely attractive, certainly compared to the US.”

He says EM stocks look relatively cheap as judged by their price-to-book (P/B) ratio, which compares share prices to the value of assets written in company accounts, known as the book value. “Brazil, China, Poland, South Korea and Russia look relatively attractive measured by the P/B, while the US now looks very expensive.”

Mr Dembik agrees that ETFs are the best way for most private investors to access EM growth, recommending iShares MSCI Emerging Markets and Vanguard FTSE Emerging Markets. Before buying an ETF, Mr Dembik recommends looking at its factsheet to get an idea of which countries and stocks the fund is tracking. You can find this information online, through sites such as Trustnet and Morningstar or simply Google the ETF.

Mr Dembik suggests some investors might also consider investing in EM government and corporate bonds. “Emerging market debt is one of the few areas where you can still find yields of 5 per cent or more. You can expect solid and healthy returns if investing for periods of at least five or 10 years.”

Conrad Saldanha, managing director at Neuberger Berman in Dubai, says most economists forecast sustained global economic expansion combined with manageable levels of inflation. “This provides a benign backdrop for emerging markets to extend their winning streak into in 2018.”

Don’t chase past winners

Sam Instone, chief executive of financial advisers AES International, warns against chasing the latest stock market bandwagon, because the danger is you will jump on board too late. He quotes legendary investor Warren Buffett who said: “I think the worst mistake you can make in stocks is to buy or sell based on current headlines.”

So rather than piling into EM, last year’s winner, you need to build a planned portfolio of low-cost ETFs tracking a wide range of global regions and sectors. “Investing regularly, maintaining a balanced portfolio and keeping your money in the market through thick and thin is the key to success over the long-term,” says Mr Instone.

Emerging markets are enjoying their day in the sun, and analysts suggest the outlook for 2018 is also bright.

Emerging market debt is one of the few areas where you can still find yields of 5 per cent or more CHRISTOPHER DEMBIK Saxo Bank