The outlook for emerging markets

"Emerging markets are unquestionably going through a transition, from a period of high expectations to one of more measured ones.”

Dr Slim Feriani, Manager of Advance Developing Markets Fund and Advance Frontier Markets Fund

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Not so long ago emerging markets were the toast of global investors. Increased productivity, low levels of leverage, high commodity prices and attractive valuations provided strong tail winds for the asset class during the middle of the last decade. In the last couple of years however, we have seen a distinct shift in investor sentiment with some of the aforementioned drivers dissipating. Thus far, 2013 has been a challenging year for investors in emerging markets. A number of headwinds made for a difficult environment, notably during May and June. These issues included rising US treasury yields, weak currencies, continued downwards earnings revisions, weak economic growth and geo-political concerns relating to Syria. Those countries with external funding requirements were amongst the biggest losers with a sell-off in their equity markets compounded by collapsing currencies, with India proving a prime case in point. Sentiment towards the asset class reached quite depressed levels and June alone saw outflows of USD20bn from dedicated emerging market funds, the largest outflow ever seen in a single month.

However, in the third quarter a point of capitulation was reached and emerging markets recouped much of their early summer declines. The initial rally was built on improving cyclical data notably from China and it gained momentum from the Fed’s unexpected announcement of “no tapering” at its September meeting.  As we enter the final months of the year a constructive case can be made for the near term outlook. If history is anything to go by, the final quarter is traditionally a good one and performance in recent weeks has been supportive of that outcome repeating itself once again. Only once in the last ten years has the emerging markets index declined in the fourth quarter and that was is the depths of the financial crisis in 2008. Comfort can also be taken from the aforementioned continuation of accommodative monetary policy in the West for longer than expected, attractive valuations within emerging markets themselves, sentiment towards the asset class being at close to a nadir and a relatively better outlook for China, the bellwether economy and largest market in the asset class.

A legitimate source of concern is the absence of a recovery in corporate earnings. Emerging markets have endured an unprecedented 30 consecutive months of downward earnings revisions. However, we believe that valuations now reflect a more modest earnings outlook with the asset class as a whole trading on a multiple of 10.4 times next year’s consensus earnings per share. In a recent research piece Bank of America Merrill Lynch suggested that emerging markets were perhaps 20% undervalued on a price to book versus value creation basis. Compared with developed markets emerging markets trade on discounts of 25-30% on the basis of trailing price to earnings and price to book ratios. Emerging markets last traded at such wide discount levels in 2004-2005. Such valuation levels have historically proven to be attractive entry points.

Emerging markets are unquestionably going through a transition, from a period of high expectations to one of more measured ones but with attractive equity valuations, weaker currencies and widespread negative sentiment, as well as longer term positive demographic trends and emerging middle classes, we are encouraged to believe that better is to come from the seasonally strong 4th quarter and beyond.

Advance Developing Markets Fund is well positioned to capitalise on this potential. It adopts a fund of funds investment approach that has been tried, tested and refined over the market cycles of the past 15 years. From a top down point of view the portfolio continues to favour those countries that offer the most appealing combinations of quality, value and growth. At present the manager’s largest overweight positions are in Russia, Thailand and Turkey while Taiwan, South Africa and Malaysia represent the largest underweight allocations. On a bottom up basis the fund seeks to combine the benefits of investing with locally based best-of-breed investment managers across the emerging world along with the potential to exploit discounts opportunities in the emerging market closed-end fund universe at all times endeavouring to be invested through the most attractive vehicles available.