Emerging markets and commodities: is it time to buy again?

Emerging market and commodities alarm clock

As is so often the case, Warren Buffett put it best. 'Be fearful when others are greedy and greedy when others are fearful,' the Sage of Omaha once said.

The message is simple: investors who hunt in packs invariably get caught out, because they either buy when prices are too high or fail to buy (or even sell) when prices are too low. Contrarians, meanwhile, capture the spoils.

There's no doubt which territory we're in now. The global stock market sell-offs seen during August came when investors panicked about the deteriorating economic environment in China, the world's second largest economy. The sell-offs were indiscriminate: asset classes beyond equities also suffered - commodity prices and many currencies fell sharply.

In some cases, this summer's asset price falls followed prolonged periods of strength, or at least stability - UK and US equities being cases in point.

LONG-TERM VIEW NEEDED

In these markets, several years of quantitative easing and abnormally low interest rates fuelled asset price inflation and lifted valuations beyond what was justified by the fundamentals. So while the correction may have released some of the steam from the pressure cooker, it's hard to argue that these markets now offer value.

In other areas, the setbacks of recent months were just the latest phase of an extended bear market. And that might give investors reason to ponder Warren Buffett's advice and consider the possibility that some assets are now so oversold that it's time to be greedy.

If so, the most likely investment candidates are emerging market equities, gold and commodities more generally, areas where investors had been nursing painful losses well before the late-summer rout.

Looking for some investment inspiration? Check out our Rated Funds in the global emerging market equities and commodities categories for some top tips.

Emerging market stocks, as measured by the MSCI Emerging Market index, fell by more than 25 per cent between September 2014 and July of this year, and the losses extended to 30 per cent or more during August. The index is now down by around 35 per cent from its high point of 2011.

Gold, meanwhile, remains more than 40 per cent off its 2011 high, while the values of other commodities have also collapsed. Most notably, the price of a barrel of oil, around $51 at the end of August, was less than half the $115 it cost a year previously and a world away from the 2007 high of almost $150. Metals including platinum, copper, iron ore and aluminium are all off sharply.

So is now the time for investors to rise above the fears of their peers? Patrick Connolly, a certified financial planner at independent financial adviser Chase de Vere, urges courage. 'The best opportunities are often in those assets that have underperformed and where there is a great deal of negative sentiment,' he says.

'Investors need to be brave to invest in assets that have performed badly, but if you're happy to take a 10-year view, there is a strong argument for selecting out-of-favour investments.'

RISKS HAVE NOT GONE AWAY

On the other hand, Philippa Gee, managing director at Philippa Gee Wealth Management, counsels caution. 'I would often pick out one asset class as a real opportunity,' she says. 'However, I would suggest that the risks in markets have not gone away. Investors should therefore be very careful about chasing the highest return and ignoring the highest risk.'

In practice, that means examining the arguments for a fightback from the worst-performing asset classes, rather than assuming they won't fall any further just because they have fallen such a long way already.

Above all, the outlook for China is the most crucial factor in that debate, for the country faces real and significant headwinds as it tries to rebalance its economy by moving away from debt-fuelled growth focused on capital investment and a dependence on exports.

It's not just China's equity market that will suffer if policymakers fail to engineer a soft landing. The country has delivered more than half of all global growth since 2008, and as the world's largest manufacturer, it has been the key driver of raw material prices.

Against that backdrop, then, are the world's most bombed-out asset classes now oversold, or set for further sell-offs?

The collapse of emerging market equities is largely about the Chinese slowdown, because the world's developing economies have become so dependent on selling their raw materials to that country.

In Indonesia, coal that used to be shipped to China is these days piled up in port, and the country's stock market is down by more than 20 per cent already this year.

In South Africa, mines that once ran at full tilt to keep pace with China's appetite for metals are laying off workers. In Thailand, sales of rubber to China are expected to fall by a fifth in this year alone.

EMERGING MARKET TURBULENCE

In Latin America, meanwhile, countries from Mexico to Colombia are stumbling now that China is no longer such a greedy consumer of commodities such as copper, iron ore and soybeans - the Colombian peso has lost 60 per cent of its value in 2015 so far.

For other emerging markets, the collapse in oil and gas prices linked to slower growth in developed markets as well as in China, plus oversupply, has done additional damage. Russia and Brazil especially have felt the pain.

As for China itself, valuations look cheap on traditional measures, following the market collapse seen this year, but that doesn't mean recovery is imminent - bargain basement price/earnings (p/e) multiples may look anything but, if earnings disappoint.

Jason Hollands, managing director of communications at financial adviser Tilney Bestinvest, says this is the question those investing in any emerging market must now ponder.

'Broader emerging markets do look superficially enticing based on 12-month forward p/e multiples, but as the data is rapidly deteriorating in China, you have to question whether the earnings forecasts will deliver,' he says. 'These apparently very cheap markets could turn out to be value traps.'

For optimists, the more encouraging theme to probe is the demographic potential of emerging and frontier markets as hundreds of millions of people join the aspiring middle classes and many more new consumers begin to participate in the global economy.

'The long-term growth story remains largely intact: growth in emerging markets continues to beat that in the West, and economic prospects should benefit from greater domestic consumption over time as emerging market populations enjoy increasing levels of wealth and disposable income,' argues Patrick Connolly.

'While emerging markets still face some headwinds, when sentiment does start to improve, it would be no surprise to see their stock markets performing really strongly.'

There's less optimism over prospects for the safe haven asset. Gold's miserable run of form, even in this era of ultra-low inflation or deflation, has left investors nursing painful losses in both nominal and real terms.

GOLD'S LOST LUSTRE

Valuing gold is difficult - it offers no yield - but the bullish case for the precious metal now hinges on the US Federal Reserve's monetary policy plans.

Jason Hollands says: 'There is a strong correlation between dollar strength and gold price weakness, because if you believe yields are going to rise on AAA-rated US Treasuries, why would you hold a zero-yielding lump of metal?'

While the Fed had been widely expected to raise interest rates as soon as this autumn, a prospect that has boosted Treasury yields and the dollar, the fragility of global markets may now mean we see a pull-back from that position. If so, expect to see the dollar fall back and gold begin to recover.

Still, such a bounce would only be short term, since rates must rise in the end. For a longer-term recovery, we will need to see fundamental demand for gold increase.

That may come if more countries start buying gold as protection against financial and political volatility, but that's a big if, even though there has been some evidence of this in recent months. China, for one, has added to its gold reserves this year.

In fact, there is no shortage of analysts who expect gold prices to keep falling. At one end of the debate, ABN Amro's coordinator of FX and commodity strategy, Georgette Boele, has made headlines in recent months for her prediction that the gold price could go as low as $800 an ounce next year, down from just above $1,100 today.

That forecast was predicated on economic recovery and rate rises in the US, but monetary policy tightening remains on the Fed's agenda, even if it takes place later than expected.

Nevertheless, it's worth pointing out that it's always very difficult to call the bottom of the market precisely, and gold is already in its second longest bear market of the past 45 years.

'I wouldn't recommend that anyone waits for the gold price to bottom. Instead, [they should] gradually buy gold and establish a position,' advises Olav Dirkmaat, a precious metals analyst at GoldRepublic.

COMMODITY VALUE?

All the factors that have weighed heavily on emerging market equities apply to commodities. In almost every case, China has been the dominant buyer of raw materials in recent years, so its sneeze has given commodity producers a horrible cold.

At current levels, everything from silver to aluminium and from lead to tin appears to offer decent value in a historical context, while soft commodities such as corn, soybeans and cocoa have also seen some weakness. That value extends to commodity-producing companies such as miners.

Even so, Neil Jones, an investment manager at Hargreave Hale, the asset management firm renowned for its special situations expertise, thinks the case for a recovery is finely balanced.

'On the face of it, the commodity sector looks most oversold, but there are good reasons for this, notably concern over faltering Chinese economic growth rates,' he says.

'However, this sector is notoriously cyclical, and the largest, most diversified producers with lower costs of production, such as BHP Billiton, could be well-placed to recover when the tide turns.'

For that to happen, demand for commodities needs to increase or supply needs to slacken. You can actually make the argument that both eventualities are now possible.

For one thing, while China has been importing raw materials, it has also been running down its stocks and will return to buying once reserves are depleted.

Moreover, with policymakers in every region of the world still focused on stimulating economic growth, there is good reason to look forward to higher demand.

On the supply side, meanwhile, the difficulties of the past year have prompted commodity producers to cut back on output; in some cases, producers have simply gone out of business. In time, this will feed through to the marketplace.

Jones says: 'When this might happen is difficult to forecast, with the likes of former Xtrata chief executive Mick Davis having already called the bottom too early. But it could be prompted by China depleting its reserves or by the Indian government finally getting to grips with its own infrastructure development.

Failing that, decisive action by the Chinese government to reinvigorate the economy - by implementing its own version of quantitative easing, for example - could see a sharp change in sentiment. Whatever the case, I suspect we are now much closer to the bottom of the cycle than the top.'

In which case, says Laith Khalaf, a senior analyst at stockbroker Hargreaves Lansdown, now is the time to start considering particular equities hit by the commodity market sell-off.

In particular, he likes engineer Johnson Matthey, with its exposure to platinum. 'After a fall of almost 25 per cent in the past few months, the stock trades at a forward p/e ratio of 14.2 times, comfortably below its long-term average,' he says.

HOW TO TAKE THE CONTRARIAN VIEW

One good way into emerging markets, suggests Mick Gilligan at broker Killik & Co, could be Utilico Emerging Markets investment trust, which has a strong long-term performance record and is managed more cautiously than other funds in the sector.

'[The managers] seek to minimise risk by investing primarily in companies displaying the characteristics of essential services or monopolies,' Gilligan explains.

'They seek to invest in undervalued investments in emerging market countries where there is political stability, economic development, confidence in the legal framework and a positive attitude to foreign investment.

Potential investors in gold funds, meanwhile, will naturally be drawn towards the best-known funds in the sector, BlackRock Gold & General and Investec Global Gold, but a less obvious option is Way Charteris Gold and Precious Metals, which invests its tiny £3.5 million portfolio in gold- and silver-exposed shares. The fund has outperformed many of its larger rivals and is highly regarded.

For direct gold investment, an exchange traded product such as iShares Physical Gold is a possibility - Morningstar says this fund is one of the cheapest ways to track the gold price.

Morningstar also flags db Physical Gold (GBP) Hedged, which provides UK investors with hedging against movements in the dollar/sterling exchange rate. With gold prices quoted in dollars, this can be important.

For exposure to commodities, Alan Brierley, an investment trust analyst at Canaccord Genuity, suggests BlackRock World Mining, which plummeted in recent years.

'Subdued global growth and the slowdown in the Chinese economy are obvious headwinds, but with the share price now back to 2005 levels and at 75 per cent of its April 2011 high, we wonder to what extent these are already discounted,' he says.

'For the investor who is prepared to take a long-term view, the shares have their attractions: the higher beta characteristics bode well when we arrive at the other side of the valley, and it remains the only commodity-focused closed-ended fund with good marketability.'

Neil Jones at Hargreave Hale says that it is worth looking beyond the most oversold asset classes for other bargains in the wake of the recent correction - including in the UK.

'There has been indiscriminate selling of assets not directly affected by slowing Chinese growth,' he says. 'Domestic-focused UK stocks fall into this bracket. UK mid-cap funds such as Lowland or Mercantile could return to favour quite rapidly.'


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