By the end of 2015 emerging market (EM) shares had meaningfully underperformed developed market (DM) shares over five years and were one of the most disliked asset classes.
It was a low point: a survey of global fund managers by Bank of America Merrill Lynch found that managers’ preference for DMs over EMs was the highest in the study’s 15-year history. That sentiment translated into investment flows and EMs were disproportionately on the losing end, leaving them available at a substantial valuation discount to DMs.
EM performance rebounded in 2016 and those same fund manager surveys now find investor sentiment to be relatively neutral. While that’s an improvement from the previous year, it’s still overly pessimistic. EMs remain attractive on broad valuation metrics, with the MSCI EM index trading at 1.5 times book value compared with 2 times for the MSCI World index, despite the fact that both indices have produced a similar return on equity.
A good performance and a compelling valuation case normally leave sentiment upbeat, but there are two fears that continue to deter investors from investing in EMs.
The first is the belief that the sector underperforms when US interest rates rise, coupled with the view that rates are unsustainably low. The second worry stems from the conviction that EMs underperform during bear markets, coupled with the view that equity markets are high and thus the probability of a bear market is above average.
However, both of these beliefs are not supported by history and clinging to them may cause investors to miss out on what may be an attractive long-term investment opportunity in EMs.
Since the 2008 financial crisis, authorities in the US, as well as Europe and Japan, have kept interest rates near zero in an effort to stimulate economic activity and have used quantitative easing to spur looser lending. Such an abundance of ‘cheap money’ is arguably unprecedented, and it’s understandable that investors worry about what happens when/if monetary policy tightens.
The view that EMs should underperform if US interest rates rise comes partly from the idea that EMs are speculative: such investments typically suffer most when interest rates rise and borrowing becomes more expensive. Conversely, when capital is cheap, as it has been in recent years, speculative investments should benefit as investors chase higher yield and turn to ‘riskier’ investments.
Pessimists about EMs also reason that higher interest rates generally cause the US dollar to strengthen; this increases the burden on developing countries with significant dollar-denominated debt and creates the potential for havoc in their financial markets. Even if this were true, today’s pessimism may be unwarranted. EMs are generally on a stronger financial footing than in the past, having heeded the call following the 1998 Asian financial crisis to build foreign exchange reserves. Additionally, a greater number of them have adopted flexible currency regimes, which help make countries more resilient to external shocks.
