Despite outperforming developed markets for most of 2016, some emerging markets still look undervalued, writes Activus Investment Advisors' Robert Talevski.
This is because prior to 2016 emerging markets had underperformed against developed markets over a five-year period.
The underperformance seen within emerging markets was due to several factors – one of which was the slowdown in China as concerns grew as it went from growing by double digit figures to mid-single digits.
This figure may seem quite high if achieved by developed economies, however this deceleration only showed that China had reached its peak in terms of growing aggressively and is now slowing down.
With China representing around 25 per cent of the MSCI emerging market index it has had a significant impact, in aggregate terms, on the performance of these markets.
This shows that China is becoming a more stable market – it has become less volatile in terms of performance.
Furthermore, household consumption is continuing to increase, especially among the middle class where disposable household income has been on the rise.
The significant downturn in commodities – affecting markets such as China, Russia and Brazil – was another factor, as were weak earnings, which in turn led to weak performances in share prices due to companies’ disappointing markets.
Economies that have had, and continue to have, high US dollar reserves saw further negative impacts due to the dollar appreciating in value due to money flowing back into US stock markets, which subsequently led to the strengthening of US markets.
Economists have seen a strong correlation in terms of the appreciation of the US dollar and underperformance of emerging markets, thus leading them to describe the relationship as inverse.
As it stands, emerging markets have a price-to-earnings (PE) ratio of 14, which is lower than developed markets’ PE ratio of 17.
As a result, there is still room for further growth as emerging markets are showing consistency in terms of their performance.
Some emerging markets have single digit PEs, showing a lack of homogeneity and that some emerging economies have further room to grow as compared to others.
Furthermore, with commodity prices appearing to have bottomed out and others nearing the bottom, emerging markets can see stability returning and volatility reducing
However, the question of whether prices will return to high levels seen previously or whether they will remain where they are persists.
In developed markets, bonds are yielding near zero whereas emerging markets are seeing significantly higher bond yields between 7-8 per cent.
Demand for bonds within emerging markets has seen an increase in 2016, but analysts believe that there is still much room for growth as the bond market continues to look attractive, especially with China’s infrastructure investment expected to increase.
China is one economy seeing stability and, although they have disappointed markets and made surprising decisions such as devaluing the yuan over three consecutive days, the worst of the fears looming over the economy have not come to light.
However, many companies are still highly geared. For state owned enterprises, most of this is government debt, but the People’s Bank of China is already acting to reduce this.
Furthermore, debt among households remains very low and isn’t currently straining the Chinese economy.
Emerging markets and the Trump caveat
A lot will depend on whether Trump can successfully implement his protectionist approach to trade deals.
This would be a negative unless it renewed US GDP growth, resulting in a knock-on effect on US consumer spending, jobs growth, world GDP growth and emerging markets.
Emerging markets contain over 80 per cent of the world’s population and with disposable income increasing among households, it is easy to assume that demand, especially within services, will continue to increase over the long-run.
Therefore, it makes sense to invest in emerging markets. As investors see more stability and reduced volatility they will become more confident by allowing their portfolio to see a bigger exposure within this area of the market.
Robert Talevski is the managing director of Activus Investment Advisors.
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