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Investors urged to hold tight on emerging markets investments

Karine Hirn cited several reasons for optimism in emerging markets.

Investors and money managers are re-evaluating their emerging markets positions and sentiments but are still searching for opportunities, despite disappointing returns this year.

A number of emerging market countries have been through serious adjustments this year, including Argentina and Turkey, said managers. Election results, changes in market sentiment and large debt issuance by some countries have led to re-evaluation of positions on certain countries.

"Early year investor exuberance led consensus emerging markets earnings expectations to be pushed to around 18% for calendar year 2018," said Edward Evans, emerging market equities portfolio manager at Ashmore Group PLC in London. "However, expectations have since moderated and been revised down to around 12% for this year and 2019. Both seem achievable," he said.

And despite increasingly difficult conditions for emerging markets, against a backdrop of continued U.S. dollar strength and rising interest rates, and worsening sentiment, managers are urging investors to stick with their equity and debt strategies.

"Emerging markets have corrected significantly since the beginning of the year for several reasons," said Karine Hirn, Hong Kong-based partner and senior adviser at emerging and frontier markets specialist East Capital International AB. The firm has €2.8 billion ($3.2 billion) in assets under management. She cited tightening monetary conditions, U.S. dollar and market strength, stronger oil prices for the first part of 2018 and "an overall increased level of geopolitical risks very much driven by the U.S. administration but also Brexit and Italy."

While these factors are external, internal developments have played negatively on markets, she said, citing Turkey and Argentina's political and economic problems earlier in the year, political and economic difficulties in South Africa, and China's deleveraging process. She said the external factors, however, have been the more important drivers.

"All that said, the correction has created very attractive valuation levels, especially when comparing (emerging markets) with the U.S. valuations, which are close to all-time-high levels," Ms. Hirn said.

In absolute terms, Mr. Evans said that emerging markets are "attractively valued, trading around 10.1 times. They trade at a notably lower multiple than the S&P 500 (index), which trades around 15.2 times." Emerging markets specialist Ashmore runs $76.4 billion in assets.

And Ken Adams, head of tactical asset allocation at Aberdeen Standard Investments in London, said the firm's assessments of different markets — which it scores on a scale of -3 to +3 considering forward market drivers, monetary environment and behavioral environment — actually show asset classes within emerging markets to be attractive.

"Although markets have fallen, and emerging markets in particular have underperformed, EM debt, EM equities and EM hard currency debt … are all markets that appear in the top five or 10" according to the firm's scores.

"When we look at these drivers and take an average, the score for EMD local currency is +1.7 — that's our strongest positive view right now. It's not exactly 'this is a fantastic opportunity,' but a decent return from where we are today," Mr. Adams said.

Emerging markets equities carries a +1.6 score — not "let's fill our boots" but there is some value there, he said.

However, Mr. Adams noted investor sentiment is "pretty negative on emerging markets assets generally."

Shifting sentiment

"Overall, sentiment is not great compared to the start of the year when there was still a lot of positive sentiment around Argentina with the big reform story," said Nicolas Jaquier, emerging market debt strategist at Allianz Global Investors in London. Turkey's difficulties then shocked investors, and now Mexico's policy direction "is a bit uncertain and (there have been) already a few policy mistakes." The firm had €4.3 billion in emerging markets debt as of June 30.

For some managers, however, adjustments in some markets harmed returns. Sergey Dergachev, lead portfolio manager for emerging market debt at Union Investment in Frankfurt, said it has been a "very tough year" for the firm's emerging market debt strategies in terms of performance, with individual strategies ranging from -4% to -8% on average this year; overall, Union has recorded minor net inflows. The firm manages more than €7 billion in emerging market assets for institutional investors.

"In our strategy we had some not very good calls this year — we were overweight in Argentina and Turkey, and of course until September or October, it was not the best bet to be overweight there," he said.

Changing positions

Current positions for emerging markets equity and debt managers focus, in some cases, on a different set of countries to the start of the year for both overweights and underweights.

AllianzGI's Mr. Jaquier said his concerns relate to some of the smaller, frontier markets that have not yet made the move to adjust to tighter conditions and still have outstanding debt.

"For example, Ukraine faces a lot of debt rollover (over) the next few years, but is still under an ( International Monetary Fund) program which makes us more confident that financing needs will be met," he said, keeping the firm overweight on the country.

But Sri Lanka positions have been reduced to no exposure on the debt side from a 2% benchmark allocation, following issuance of "a lot of dollar bonds the last three or four years, now coming to mature and need to be rolled over." He said there is also little evidence of an IMF program for the country next year and political noise is getting louder. Oman also has been reduced to zero exposure from a 2.5% benchmark allocation.

India is also on his concerns list, related to politics and policies. The country has elections next year and the fallout of policy mistakes — such as demonetization, which led to a "cash crunch" — have Mr. Jaquier worried. He does, however, like Brazil thanks to the outcome of its election last month. He thinks much-needed social security reform will go ahead next year and that growth will rebalance.

Sovereign debt overweights for Union's Mr. Dergachev include Argentina, while underweights include Sri Lanka, South Africa and Russia. The biggest corporate debt underweight in strategies is Chinese credit. "There are emanating default risks, so individual credit quality selection is becoming more and more important in China," he said.

In corporate debt, Mr. Dergachev likes Poland, which is a "good diversification play" in terms of quality in both the European and broader emerging markets context, and Indonesian companies.

On the equities side, East Capital's Ms. Hirn said the firm likes Baltic countries despite scarce liquidity; that "Russia's macroeconomic backdrop is better than most people would think," with the country's equity markets up about 11% in euro terms this year vs. an index loss of about 8%; and executives are also happy that growth in China has slowed down.

"It is interesting to read so many negative headlines on Chinese growth when we should actually be praising the Chinese for their undeniable priority to focus on qualitative growth, not quantitative growth," said Ms. Hirn.

And going forward, it might be that investors change their approach altogether in terms of the types of emerging markets stocks they focus on.

"We've gone through a very interesting period in terms of growth and value dynamics — it has been a period where growth stocks and relatively expensive stocks have performed much better than value stocks, and that was very much an emerging markets theme, as well (as global)," said James Donald, managing director and head of the emerging markets group at Lazard Asset Management in London. "At the end of the 1990s we had very much the same situation … Then we had a 10-year period where value stocks did very well against growth stocks. So we're thinking there's a reasonably good chance we may go through a change of leadership in the not-too-distant future."

Mr. Donald said any wholesale shift to value "would be a very big event … We've seen deep value starting to do well again after a very long period of underperformance. I think the jury is still out but if things do occur similarly to the past … it would be a sea change," he said.