05 March 2014

Ireland, Dublin

Unrest and uncertainty in the world’s emerging markets has contributed to a sell-off in assets in recent times. Events in the Ukraine and Turkey have highlighted the volatility of emerging market countries in Europe. More global examples include the political instability which has affected Brazil, Thailand and South Africa and been a feature of the Middle East since the Arab Spring of 2011. The recent currency devaluation in Argentina, growing concerns about domestic credit expansion in China and fears over the removal of quantitative easing in the US have caused acceleration in fund flows out of emerging markets. Concerns reached a peak in the latter part of January, when emerging market equity and bond indices fell sharply.

However, now is not the time to rush for the exit. This recent turmoil and the sell-off in emerging market assets should not deter long-term investors. Political uncertainty and volatility will always be more challenging in emerging markets. What’s more, fundamental factors, valuations and investor positioning all suggest that those who can tolerate short-term volatility and have a longer time horizon should be rewarded. The years 1994 and 1998 were very difficult for emerging market investors but, in both periods, markets recovered and subsequently provided very strong returns. We believe the current situation will prove to be similar and that there are a number of reasons why the strategic case for investing in a diversified basket of emerging markets remains intact.

Emerging market economies have positive demographic profiles, lower debt levels than many developed market economies and high foreign exchange reserves. They have higher long-term growth potential, driven by productivity improvements and international capital flows in the form of direct foreign investment. These structural factors are now supported by increasingly attractive valuation metrics, both on a stand-alone basis and relative to developed markets. Equity valuation measures such as relative price-earnings ratios are at their deepest discount to developed markets since 2005. Moreover, recent survey evidence suggests that global fund managers are significantly underweight in emerging markets compared to long-term average exposures. On bond markets, following the recent sell-off, local currency bonds issued by emerging market governments offer as high a yield now as they did 10 years ago, even though the underlying creditworthiness of these governments has improved markedly over that period. This again is indicative of good valuation levels for investors with a strategic timeframe in mind. Accordingly, those already invested in emerging markets as part of a well-diversified portfolio should hold their nerve. For those yet to invest, the current correction provides an attractive entry point.

Undoubtedly there are risks. With elections due in over 20 emerging market countries, politics will be to the fore this year. Additionally, the fortunes of the Chinese economy will be watched closely, with markets likely to be nervous of any signs of a hard landing. As with all return-seeking investments, investors need to be aware of these risks and proceed with their eyes open.

Irish investors, both institutional and retail have been increasing their strategic allocations to emerging market assets in recent years. We believe that such moves are likely to be rewarded over time.

Noel Collins, Senior Investments Consultant, Mercer