There are loads of good reasons to worry about the outlook for emerging markets.
There’s the ugly geopolitical outlook. Things may get worse in Ukraine and the Middle East. When investors start worrying about these sorts of risks, emerging markets are often one of the first assets they dump, whether it makes sense or not.
There are also plenty of people who worry about China’s financial system. They fear that a credit bubble in China could deflate the whole Chinese economy when the bubble bursts.
Then there’s the US. As the US central bank gradually raises interest rates and stops printing money, investors will withdraw cash from emerging markets and bring it ‘home’ to the US. Or so the theory goes.
There’s at least an element of truth in all these concerns.
So why do I think that now is a good time to buy?
Markets are fretting too much about higher US interest rates
I can see why investors worry about how tighter US monetary policy will affect emerging markets. After all, when former Fed chief Ben Bernanke first hinted at reducing quantitative easing (money printing), markets across the globe were hit hard.
But history suggests that these fears are overdone. If you look at what happened on the last two occasions that the US pushed up rates significantly, emerging markets weren’t hugely affected, according to Capital Economics. The last time a US tightening made a big impact was when interest rates were raised in 1994.
However back then, emerging economies were far more dependent on the fortunes of developed markets than they are now. Today, the likes of China are no longer ‘just’ supplying cheap labour or commodities to the West. Instead, these countries have growing middle classes with money to spend on their own countries’ goods and services.
What’s more, the tightening in 1994 was unexpected and happened quite quickly. That’s very different from the situation now. The monetary tightening that we will see over the next couple of years has been extremely well flagged. One thing is clear – Fed chief Janet Yellen doesn’t want to spook the markets.
As I result, I think any upcoming tightening is already ‘priced in’ to emerging market share prices. In fact, this anticipated tightening is probably the main reason that emerging-market share prices look reasonably cheap right now.
That said, you should be picky about which emerging markets you choose to invest in. For example, Russia looks very cheap if you focus on the traditional investment ratios. For example the latest figures on Mebane Faber’s IdeaFarm website put Russia on a cyclically adjusted price/earnings (Cape) ratio of just 6.4. (We explain how the Cape ratio works here, and why we like it.)
But given that Russia now faces significant economic sanctions, the risk levels are too high for me (although you may not agree – Merryn is more tempted than I am, as she notes in this blog post). I also worry that countries in ‘emerging Europe’, such as Poland and the Czech Republic, could also be affected if the Ukraine mess worsens.
For me, China and Asia in general look like the most attractive options. According to Faber, China currently has a Cape ratio of 11.8 – much lower than the UK, on 14, and the US, on an eye-watering 26. So China is a far cheaper market, and also has much more growth potential in the long term.
China certainly has its challenges. Its next stage of growth won’t be easy, and it’s possible we’ll see a blow-up in the financial sector. However, on the more positive side, the government’s gradual economic reforms should help to offset some of these risks (you can read more on these changes, announced at the end of last year, here).
Last month’s strong export numbers from China were also encouraging. As Jan Dehn, an emerging markets fund manager at Ashmore, points out, strong exports should make it easier for China to cope with the ongoing attempts to shift its economy towards a focus on “less sophisticated domestic sectors”.
I also think that South Korea looks particularly interesting just now. The market has always been cheap compared to most similar nations, because of concerns about corporate governance. But now the government is pressing businesses to pay out larger dividends and generally take better care of shareholders, which can only be good news for investors.
How to invest in China and Asia
If you just want to invest in China, I’d suggest two funds. Firstly, there’s the iShares FTSE/Xinhua China 25 ETF (LSE: FXC). This is a nice simple exchange-traded fund (ETF) with relatively low charges. My second suggestion is the JP Morgan Chinese investment trust (LSE: JMC). The fund has delivered a strong performance since it launched in 1993, and I own shares myself. It’s also trading on a discount of 10.4%. That’s much larger than a lot of investment trusts these days. (This discount means that if you buy £900-worth of shares, you effectively end up owning assets that are worth £1,000.)
If you’d prefer to put your money into a fund that invests across Asia, take a look at the Baillie Gifford Pacific fund. This invests in most countries in Asia, apart from Japan, and it’s delivered an 80% return over the last five years – a better performance than most of its peers. It’s run by an up-and-coming fund manager called Roderick Snell.
As I’ve said, I’ve already invested some of my savings into China. I’ll be looking to increase that investment in the near future.
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