Investors eyeing emerging markets with some caution

Money manager executives' fingers are hovering over the “buy” button on emerging markets.

On one hand, a potent combination of falling markets, China's slowdown and currency weakness continues to batter the emerging world.

On the other, the prospect of a U.S. rate hike, relatively cheap valuations and an anticipated widening of the GDP growth ratio between developed and emerging markets is attractive.

“Emerging markets right now do offer some relative value compared to developed markets, but I have to emphasize "relative' — they are not ridiculously cheap relative to previous bear markets,” said Russ Koesterich, global chief investment strategist at BlackRock Inc. in San Francisco. “But given that they have been underperforming for a long time, and a lot of the gains in the developed markets have been driven by multiple expansions in the last four or five years, there is some weight to the argument to increasing (positions) in emerging markets.”

Investor sentiment has been noticeably weaker — with even the faith of long-term-focused institutional investors beginning to waver.

Data from eVestment LLC show $7.5 billion of net outflows within its All Emerging Markets Equity universe over the three months ended June 30, which followed four consecutive quarters of net inflows. The provider's All Emerging Markets Fixed Income universe shows debt has been out of favor for a longer period of time — it recorded net outflows for the past four quarters, with the three months ended June 30 showing net outflows of $2.6 billion.

None of the money managers contacted by Pensions & Investments said they have experienced institutional investor outflows. In fact, they are seeing some clients choosing to add to positions as they believe markets are set to turn around.

However, some of the money management executives themselves have their fingers firmly pressed on “pause” when considering whether to buy emerging markets securities.

“The conclusion is that we think it is too early,” said Wouter Sturkenboom, London-based senior investment strategist at Russell Investments. “That is predicated on two things — the business cycle development in emerging markets is still very challenging. On top of that, we look at sentiment, as a combination of momentum and contrarian indicators. Momentum is negative, whereas contrarian (indicators) are starting to pick up interesting buy opportunities. The combination is neutral — we are looking for it to pick up.”

Emerging markets have been battered by years of underperformance, weakness in their local currencies relative to the U.S. dollar, and more recently by the slowdown and uncertainty in China.

The MSCI Emerging Markets index returned -14.5% in U.S. dollar terms year-to-date through Sept. 3 (-8.7% in local currency). In 2014, the index lost 1.97% in U.S. dollar terms, following a loss in 2013 of 2.4%.

“There are plenty of reasons to be worried on emerging markets,” said Marcus Svedberg, Geneva-based chief economist at East Capital International AB. “Growth has been decelerating for years; the (Fed interest rate) hike; oil prices are still half what they were a year ago; China — both growth concerns and the exchange rate adjustment; and then you have individual problems. To be bearish on emerging markets, you can just take your pick.”

Gary Greenberg, London-based head of emerging markets at Hermes Investment Management, said: “If you did a weather report, you would see scattered showers everywhere.”

On the equities side, Mr. Sturkenboom added that while some valuations are attractive, it is still too early to buy into them. “It is still unclear from a macro top-down (view) that the valuation attractiveness is real, or to what extent it is a value trap,” he said.

Anders Faergemann, London-based senior sovereign portfolio manager at PineBridge Investments, agreed: “With the U.S. dollar on an upward trend and no evidence of a turnaround in the EM growth outlook, it may be too soon to move back into EM equities.”

Robeco Group NV, on the other hand, has been overweight emerging markets relative to developed since April 2014.

“The macro (view) is positive, valuations are a bit positive, earnings are neutral, sentiment short-term is negative if you are a follower — if you are a contrarian, this is a good time to go against the bearishness and the flow,” said Wim-Hein Pals, head of emerging market equities at Robeco, Rotterdam, Netherlands.

Mr. Pals is looking forward to the first hike by the Federal Reserve, “contrary to the consensus opinion that emerging markets will be in trouble again. In previous episodes we have seen that the start of the bull run for emerging markets was 2004-'05 — when the Fed started its last hiking cycle,” he said.

And Bill Barbour, Singapore-based client portfolio manager, global emerging markets equity, at Eastspring Investments, said: “The number of value outliers has increased quite rapidly recently and now we have a far larger pool to draw on.”

Messages are as mixed on the debt side. Some managers are ready to add to positions, while others believe it is not yet time.

“We have had quite a bit of correction, particularly on the local currency side, and more recently also hard currency, sovereigns and corporates,” said Zsolt Papp, senior client portfolio manager, emerging market debt, at J.P. Morgan Asset Management in London. “Counterintuitively for us, the correction hasn't gone far enough — particularly on the hard currency side, spreads are still below comparable levels to the euro crisis (in) 2011. The money manager remains defensively positioned. “We think there is more to come in terms of correction.”

Others are closer to moving. “We are getting to the point where it gets interesting,” said Colm McDonagh, London-based head of emerging market debt at Insight Investment. “We want to be positioned to have cash to take advantage of it when the time is appropriate ... and I think we are entering that.”

Nuances are beginning to appear on a country-specific level, he said. “We have periods where markets get overbought on too much excitement, and oversold when people become far too pessimistic. I'm not saying uniformly they are in a good place, but it is far more nuanced than a "sell all' view.”

David Riley, head of credit strategy at BlueBay Asset Management LLP, in London, said the question of adding to positions in emerging markets debt is coming up with institutional investor clients. “On a tactical asset allocation basis, we would be starting to increase some exposure to emerging markets,” in particular to local currency, “because of the scale of the sell-off that we have seen.”

The outlook is getting brighter. Emerging markets GDP growth is forecast to fall to 4.2% for 2015 from 4.6% in 2014; and rise in 2016 to 4.7%.

Risks remain, and differentiating among countries is “probably one of the most important things for investors,” said Mr. Koesterich. The promise of structural reform is a major checkmark for some countries.

Mr. Greenberg said the chances of reforms coming through in a number of markets is reasonable.

Mr. Papp added: Concrete policy action “could really help build up confidence in emerging markets policymakers (who) didn't use the good years to implement these reforms, particularly on the fiscal side.” n