Look past the dramatic headlines about Turkey, Argentina and China - healthy returns are on the horizon.
Being an investor in emerging markets can feel like riding an endless roller coaster at times; there are some terrific highs followed by hair-raising drops.
The past two years has perfectly encapsulated what it is like to invest in emerging markets.
In 2017, the conditions were almost perfect, with a synchronised growth surge from the world’s major economies and rising investment, helping fuel an uplift in trade. The technology hubs in South Korea, Taiwan and China did particularly well as a result of the investment boost.
Steady inflation meant that central bankers did not feel the need to interfere by raising rates, which acted as a further catalyst for growth in emerging market economies.
As a result, company earnings grew rapidly, despite the 'America first' mantra causing concerns about the balance of global trade, and emerging market equities ended the year up 40 per cent.
Taken in isolation, most people would have agreed that emerging markets had a fairly rosy future. But the first half of 2018 was always going to be difficult.
All of the indicators suggested that growth was nearing – or had already – peaked, a reflection of where emerging markets were in the economic cycle rather than an indication of weakness. Nonetheless, it meant that emerging markets have faced severe headwinds.
Alongside this, central bankers and the bond markets arose from their slumber, increasing interest rates to head off rising inflation. History tells us that emerging markets don’t fare particularly well when interest rates in developed nations – particularly the US – start to go up.
True to form, as the Federal Reserve took action it unmasked some ugly truths about certain emerging markets, with Turkey being the most prominent example.
Dangerous levels of debt and a political stand-off with the US caused a run on the Turkish lira, a spike in inflation and a stock market crash in the country. Argentina was next, as a similar political situation erupted.
In addition, China has been tapping the brakes as it irons out some of the potential risks related to its multi-year credit binge, while protectionist rhetoric in the US has hardened into a full-blown trade war.
As a result, emerging market stocks have fallen by 8 per cent, in dollar terms, so far this year. That loss falls to just over 3 per cent if you convert this into local currencies. But, on the evidence so far, it seems as though Latin America and Eastern Europe are the worst hit by investors’ retreat from emerging markets.
So, where does that leave emerging markets, and how should investors be considering them?
A strong track record
First, emerging markets have been very fruitful for investors over the past 40 years.
Since the 1980s, performance has been positive 66 per cent of the time, rising to 71 per cent if you remove periods of recession.
If, like us, you cannot see the next recession on the horizon, then the odds that emerging markets will outperform are stacked in their favour.
Our analysis suggests that stock prices tend to follow company earnings revisions, which have softened in recent times amid the headwinds facing emerging markets. But we see these headwinds tailing off in the months ahead, which should bring about a welcome return to stock market growth.
We believe that the campaign trail for the US midterms should cool talk of trade wars for a while, which should support emerging market stocks.
Also, it is likely that people will soon realise that the policy errors that have crippled Turkey are not symptomatic of emerging markets as a whole.
So, while investors are right to be alarmed by recent dramatic headlines about emerging markets, we firmly believe that it is just a matter of time before we see a return to healthy returns. It will be the patient investors, with long-term outlooks, who profit from this.
Will Hobbs is head of investment strategy at Barclays Smart Investor.
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