This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Tom Becket, CIO of PSigma Investment Management, considers the future of emerging markets.
From a markets’ perspective, 2013 was very easy to describe; it was a time to take as much risk as possible in the developed world and as little as possible in the emerging world. Starting with the bad news, emerging market economies and assets had a very difficult 2013. With China’s growth slowing and idiosyncratic issues across a surprisingly large number of countries – including Thailand, Turkey, and Ukraine, investors fled from developing nations’ stock markets, bonds and currencies.
This caused sharp moves lower in many assets, further unsettling skittish investors, who chose to repatriate their money back to the US, UK, Europe and Japan, much to the benefit of their stock-markets. Over the course of the year, the MSCI Emerging Markets Equity Index fell by 4%, whilst many bonds and currencies fell by greater amounts. In terms of relative valuations between emerging market and developed world assets, we are now at almost unprecedented levels, which we believe offer tantalising long term opportunities for patient investors. With growth in the industrialising world likely to remain healthy for the remainder of this decade, we strongly believe that emerging market assets will return to favour before too long.
As we gaze forward in to 2014, there are three main risks that we are worried about; namely “Disappointment”, “Deflation” and “Default”. The first of our “three Ds” concerns the levels of extreme optimism that we are detecting by the wider investment community. There appears to be a high level of complacency from investors, who are keen to grab the green shoots of economic recovery as sufficient evidence to take increased risk in their portfolios.
Of course, this seems to make sense, not least given our core view that, after six years of lacklustre output, 2014 will finally see a year of solid and broad growth from the global economy. However, our immediate fears centre upon the uncomfortable fact that the prices of many assets have soared in the last two years, stretching valuations and bringing forward the possible future returns from assets. In effect, we have factored in tomorrow’s positive economic momentum and translational effect upon corporate profits in to today’s prices. Any disappointment at an economic or investment level is likely to be punished; potentially harshly so. It has been a very long time since there has been a “proper” correction in developed world equity markets and our view is that markets are at risk of a setback in the coming months.
Despite our hesitant short term view, we believe that any period of negative performance from equity markets is likely to be the prelude to a continuation of the equity market recovery that started in 2009. While we would argue that many share prices are “full” it is hard to spot any concerted signs of ridiculous valuations. Furthermore, it is still relatively easy to make a positive case for equities; balance sheets are mostly strong, the cost of borrowing is low, earnings growth is positive, dividends are attractive and companies are still aggressively buying their own shares. Another potential confidence boost can be found in the burgeoning levels of corporate mergers and acquisitions. Equities remain our “asset class of choice” for the next five years.
We are worried about what is happening in Chinese money markets, as the Chinese authorities attempt to purge the unhealthy excesses of the last few years’ rampant credit creation. While we remain bullish on both China and Emerging Markets in the medium to long term, we need to see how this battle plays out in the coming months. We are hopeful that we will garner further conviction to increase our exposure to this area of great opportunity, but there is undoubtedly the chance that the Chinese will let a financial entity default “pour encourager les autres”. Closer to home, we are amazed by how blasé investors have become about the teetering debt piles in the periphery of Europe. This is another situation that is far from its final act and will certainly create moments of panic again in 2014.
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