Can emerging markets weather the China storm?

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Emerging markets have significantly underperformed their developed counterparts over the last one, three and five years. Year-to-date to the end of October, the MSCI Emerging Markets index has fallen 9.5 per cent in US dollar terms, while the MSCI World index for developed country stocks has returned 0.3 per cent. Emerging market equities continue to be negatively affected by heightened investor concern over interest rates and weak economic newsflow out of China.

China, the largest constituent in the MSCI EM index at 24 per cent, has been highly volatile this year. Following a strong rally in April and May, driven by hopes of monetary easing, data pointed to a deepening slowdown in the economy.

Measures introduced by the Chinese authorities, such as encouraging banks to buy shares and banning the sale of equities by leading shareholders, somewhat stabilised the market but the unexpected devaluation of the yuan on 11 August raised uncertainty over economic policy and triggered a collapse.

Also among the worst performing emerging markets is Brazil, with the MSCI Brazil index falling 36 per cent year-to-date. The country’s continued economic underperformance, deterioration of fiscal accounts, high unemployment and even higher inflation have all added to asset volatility. In addition, low commodity prices and China’s slowdown have negatively affected its exports of iron ore and other raw materials.

Meanwhile, despite being in recession, Russia has been among the largest outperformers of the year, with the MSCI Russia index returning 15.5 per cent year-to-date. After a sell-off in 2014, the market rebounded in the first half of 2015 as the oil price recovered and the crisis in eastern Ukraine eased. Also, while the currency devaluation towards the end of last year was painful for consumers, it has delivered a boost to the competitiveness of Russian exporters.

In terms of outlook, emerging markets remain a difficult call, having been a serial underperformer for some time. Those of a bearish persuasion still see sizeable problems ahead. Economic slowdown, capital outflows from China, high levels of emerging market corporate USD debt, further currency devaluations and more profit declines have rekindled memories of prior bouts of emerging markets stress.

The main issue is the extent to which the Chinese economy slows. There is no doubt it is slowing and will continue to do so but it is gradually undergoing a transformation: consumption is now 60 per cent of the economy, retail sales volumes continue to rise in excess of 10 per cent annually and job and wage growth remain strong.

Indeed, many emerging market economies are considerably better positioned relative to past crises. Most no longer have pegged exchange rates, currencies have already depreciated substantially and, in aggregate, they run a current account surplus.

Fund picks

Obvious contenders for emerging market equity exposure are Aberdeen and Stewart Investors (previously First State). Their expertise has led them to consistently deliver strong performance over most time periods, resulting in concerns over capacity and soft closures. Aberdeen focuses on quality, sustainable, competitive business models with high returns on assets and capital, while Stewart Investors favours firms with sustainable drivers of earnings growth and high standards of corporate governance.

We also have a high regard for Fidelity Emerging Markets, which is managed by Nick Price and his team of four portfolio managers. The focus is on quality companies with proven track records of superior profitability and high returns on equity, which are able to fund growth using free cash flows.

Another strong choice is JOHCM Global Emerging Markets Opportunities, managed by James Syme and Paul Wimborne. Unlike many peers, the investment approach is driven by top-down analysis of the 23 countries making up the MSCI EM index. At the stock level, the managers evaluate companies for their value and growth appeal. We also like PFS Somerset Global Emerging Markets, which benefits from experienced manager Edward Robertson and the firm’s close-knit team.

The emerging market small-cap sector is still relatively limited. However, our pick in this area would be Templeton Emerging Markets Smaller Companies, which is managed by the Templeton research team, whose experience in emerging market equities dates back to 1987. The strategy targets growth stocks trading at significant discounts and generally has two thirds of net assets in small-caps.

There is also an increasing number of emerging market income funds available. The managers of these funds believe a dividend discipline tends to lead to companies with stronger corporate governance and better capital allocation. We like PFS Somerset Emerging Markets Dividend Growth, Polar Capital Emerging Markets Income, and JPM Emerging Markets Income.

Lena Tsymbaluk is manager research analyst at Morningstar