Emerging market equities have struggled year-to-date, having returned -6 per cent versus 13 per cent from their developed counterparts.
Performance within the region has been disparate. Venezuela has returned around 66 per cent during this time, whereas India has trailed on the other end of spectrum, having fallen 22 per cent.
We are underweight emerging markets, despite the fact that some investors are now pointing to cheap valuations. The question we are asking, is whether prices are discounting some huge risks.
We do not believe that we are seeing a redux of the 1997 Asian crisis. But we are asking if there is more pain ahead and whether any revival, between now and the end of the year, will reflect nothing more than a tactical bounce.
The first half of 2013 started with a bang for risk assets. By the start of the second half of the year, however, concerns about the US Federal Reserve tapering its asset purchases had taken a firm hold, leading to a repatriation of assets into developed world markets. Emerging equity funds came under pressure to the tune of $7bn; emerging markets bonds suffered outflows of just over $4.5 bn.
Looking at valuations, emerging market equities – which are trading on around 12 times earnings, are certainly cheaper than the UK and developed markets. These are trading on price/earning ratios of 14 times and 16 times earnings respectively. But are emerging market equities cheap enough, given the potential risks?
There are several areas of concern. Most obvious is the Syrian crisis, and the potential negative impact of an oil price spike on economic growth. When faced with this degree of uncertainty, markets have, in the past, corrected by 10 per cent or more.
Other major problems include the end, or the perceived end, of the commodity super-cycle and political noise. Historic credit excesses also need to be addressed, for example, in China, while it can be argued that investment outflows are exacerbating the cyclical and structural inefficiencies, and inflation in India. To make matters worse, in Brazil structural reforms and capital spending are lacking to unleash the next wave of growth while domestic demand remains weak.
With the Fed yet to instigate tapering, we would expect emerging markets to continue to underperform developed markets until the growth and trade cycles inflect.
However, we believe the biggest risk to the emerging world is the potential for policy error by the regional central banks, especially as current accounts have contracted.
We now have the reverse, which could precipitate currency risk and inflation risk: this is what the market is telling us. The discount on which emerging markets are trading does not mean they are relatively cheap.
In recent years, strong growth and performance have perhaps disguised the fact that the emerging markets remain volatile areas in which to invest. What we are seeing today, with these markets behaving like a higher beta asset class, should come as no surprise.
But it has posed a number of questions for investors. Is it possible for the US and for the emerging markets to outperform at the same time? Are we seeing a re-coupling? And what are the implications for portfolios?
Meanwhile, which asset classes are likely to help mitigate emerging market underperformance? We expect investors to revert to old-fashioned havens such as high quality sovereign debt, gold – although we do not invest here – and, of course, the US dollar.
Markets tend not to change until there is severe disruption, and maybe this is yet to come in the emerging markets. For now, we are happy to bide our time and not be too contrarian. Yet.
David Coombs is head of multi-manager investments Rathbone Unit Trust Management