Together with other risky asset classes, Emerging Market (EM) equities have rallied strongly since the beginning of year. Despite underperforming developed equity markets, the rally came at a time when investors were planning for the worse following a torrid end to 2018. In the EM space, on a year-to-date basis, equities outperformed EM bonds – a favourite asset class with local income hungry investors. In USD terms, the former gained 12.5% while EM sovereign bonds and corporate bonds gained approximately 6% and 5% respectively.

What led to EM equities rallying since end of December last year? A stable USD is usually positive for EM equities and as the FED’s tone on interest rates switched and signaled that it expects to be more patient with further rate hikes, EM equities jumped together with other risky assets. The USD has been rather stable over the period. At the same time China increased stimulus through tax policies to support growth. In addition, the US-China trade talks have turned positive and oil prices have recovered this year giving a boost to investors’ sentiment. All these factors together have led to higher returns and lower volatility during the first four months of the year.

Since the beginning of the year, developed market equities, as measured by the MSCI World Index (which excludes EM equities), gained 16.5% hence outperforming EM equities by nearly 4% when measured in USD terms. The outperformance of developed equities has persisted for most of the past decade, with the MSCI World Index outperforming the MSCI Emerging Markets Index both on a five and 10-year basis. Developed market equities managed to outperform despite experiencing less volatile returns.

The saying, higher returns come at the expense of higher risks, did not hold in this case. In other words, EM experienced a higher level of volatility but generated lower returns for investors compared to developed equities. The picture is different if we were to measure performance since the beginning of 2001. Since then, EM equities generated an annualized return of just over 9% compared to 5% generated by developed market equities. During the same period, EM was also more volatile but generated a better risk-adjusted return compared to developed market equities.

Based on the above, over the past decade, investors who took more risk and opted for EM over developed equities, did not generate the desired returns. However, those EM investors who invested, and remained invested over a 15 and 18-year period generated superior returns. Time and time again, long term investors were proved right if they tapped in EM equities when the asset class sold off. Investing in EM is no short-term play.

During 2018, which happened to be the worst year for developed equities since 2008, EM equities declined by 14.6% while developed market equities lost 8.7%. When markets sell off, all risky assets tend to lose value. The riskiest of assets tend to lose more at a faster pace. This is usually the case with EM. It is normal to see EM assets lose value following weaknesses in countries such Turkey and Argentina or smaller nations in the EM space. While news surrounding such countries do impact sentiment, EM experts believe that such countries pose little macroeconomic risks and risks of contagion.

Notwithstanding what was happening in equity markets during 2018, corporate cash flows and earnings were generally resilient. Fears of higher interest rates exerted pressure on both growth and inflation expectations, which however did not impact EM countries solely. However, economic figures show that debt ratios are higher in developed countries and based on fundamentals, EMs should be more resilient given the fact that their reliance on debt funded in USD has declined while most EM counties are running a current account surplus and have shifted to floating exchange rates. Moreover, middle-class population in EM is growing, making these countries more self-sufficient and less dependent on foreign demand. Economic data show that EM exports, which remain a key growth contributor, are becoming less dependent on developed markets.

Positive economic data and market sentiment could lift EM markets further and it is very likely that the next decade will be less hard on EM countries. Many have stronger fundamentals, embraced technological advances, experiencing increasing domestic demand and are less reliant on foreign currency funding. Most importantly debt ratios and current accounts are positive and in better shape than some of the largest economies in the developed world. Uncertainties will remain and naturally investors should expect EM assets to be more volatile, yet based on fundamentals, EM equities should be expected to generate positive returns and over the long-term superior risk-adjusted returns compared to developed countries.

Long-term investors should not shy away from EM equities. Despite the volatility which such equities add to investors’ portfolio they should be seen as a main growth contributor. Many local investors prefer EM bonds over EM equities because they are usually a good source of high income. However, if income is not a primary objective, there is definitely more value in EM equities over EM bonds for the long-term investor. While the ride in EM will surely be a bumpy one, investors should have money readily available to tap again in this market when equities decline on panic selling and unfounded investor fears.

Source: MSCI

Gabriel Mansueto is Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]