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Are emerging markets at a crossroads for investors?

The last five years have been tough ones for emerging market equities with the MSCI Emerging Markets Index underperforming the MSCI World Index of developed markets in five consecutive twelve-month periods and lagging it by 42% in sterling terms over the five years to end of March 2016.

The malaise began in 2010 as China began the painful process of attempting to shift its economy away from internal investment and exports towards developing the Chinese consumer. This shift has been accompanied by a slowdown in its growth rates with GDP growth declining from 10.6% in 2010 to 6.9% in 2015. That deceleration has in turn reduced demand for raw materials. Tumbling commodity prices have particularly impacted certain emerging market economies, which are heavily exposed to areas like mining (South Africa) and energy (Russia).

Emerging markets also faced renewed headwinds from 2013 when the US Federal Reserve announced plans to reduce its massive ‘Quantitative Easing’ stimulus programme, which had provided vast amounts of liquidity to global stock markets in the wake of the global financial crisis. By keeping borrowing costs down across the globe the Fed had enabled developing market companies to borrow vast amounts of debt. According to the International Monetary Fund, US dollar denominated corporate debt (excluding financials) has soared from $200 billion in 2003 to almost $2 trillion today. As expectations of a tightening of US monetary policy grew, the US dollar strengthened significantly against other leading currencies until the end of 2015, which pushed up the costs of servicing dollar debts for emerging market companies.

Yet more recently there has been a chink of light at the end of the tunnel, with the US dollar having eased in recent months as expectations of a normal interest rate hiking cycle in the US has abated and the downward slide in commodity prices has been halted. While the emerging markets continue to face challenges and worries persist about the alarming growth of debt in China (which is estimated to have risen to 237% of GDP) current valuations appear to reflect a lot of the risks with emerging market equities standing at 35% discount on price/earnings basis to developed world equities, which is large by historical standards.

Some of the key risks of investing in emerging countries is poor corporate governance, corruption and political instability. These risks have been brought home to international investors in recent years as Russia has become subject to sanctions following its seizure of Crimea and intervention in Ukraine, in South Africa where President Jacob Zuma has been embroiled in a corruption scandal over the use of public funds to improve his private mansion and notably in Brazil, where President Dilma Rousseff is facing impeachment. These serve as reminders that while investment in emerging market economies can provide excellent long-term opportunities, a discount for the risks involved is probably warranted.

At the moment, Latin America is a sub-region of the emerging market universe which has come heavily into focus as there are signs of a political shift away from the left, raising the prospect of renewed attempts at economic reform. Last year saw the replacement of Argentina’s President Cristina Kirchner, who is currently embroiled in a court case for fraud, with centre-right candidate Mauricio Macri. What has excited investors most recently however are moves to impeach President Dilma Rousseff in Brazil, anticipation of which has spurred a 32% rally in the MSCI Brazil Index (in sterling terms) over the last three months alone. Brazil matters, as it makes up almost half of the MSCI Latin American Index and is 6.6% of the broader MSCI Emerging Markets Index.

While the prospect of renewed political reform and pro-business governments in Latin America is positive from an investment perspective, investors should nevertheless tread carefully and resist the temptation to throw caution to the wind and rush to invest in a specialist Latin American fund on the back of recent market euphoria. The prospects for Brazil may well be turning a corner but the country faces many headwinds after years of economic mismanagement and a ballooning budget deficit. Instead we believe that the vast majority of investors should achieve their exposure through global emerging market funds or investment trusts, where a team can evaluate the overall balance of opportunities and risks across different regions.

One global emerging market trust that we rate highly and has an overweight position in Brazil is the JP Morgan Emerging Markets Investment Trust. As at the end of March 2016 it had 11.4% of its portfolio in Brazil and 5.7% in Mexico. The trust also had a large 23.3% position in India (which is 8% of the index) which is seen as one of the brighter spots in the emerging market universe. Notably the trust is also underweight China, with 12.6% of the portfolio invested there compared to a 23.9% index weighting. Other emerging market funds we rate highly are Fidelity Emerging Markets and Newton Global Emerging Markets.

The value of your investment can go down as well as up, and you can get back less than you originally invested.

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