Investors have a decision to make: stick with the expensive developed world or take a risk on cheaper emerging markets. Cherry Reynard reports...
February saw emerging markets hit once again. As Russia moved into the Ukraine and contagion began to hit other markets, there were no signs of investors taking advantage of lower valuations.
Where investors were willing to commit money, they stuck to safer havens, such as the UK. That said, there were signs investors were redeploying some of their risk budgets towards European equities, which benefited from being the ‘least bad’ option.
The first two weeks of February saw some of the most significant selling pressure on emerging markets. Data from EPFR Global for the week to 5 February showed outflows from emerging market equity funds year-to-date exceeded those for all of 2013.
Where did the smart money go in February?
Capping the longest consecutive run of outflows from emerging markets since 2002, $6.37bn fled the sector over the week, bringing year-to-date outflows to $18.6bn.
The fear was not confined to emerging markets. Investors also moved away from US equity funds, which saw $24bn of outflows. This made up the bulk of the $28.3bn that moved out of equity markets in total.
The cash mostly found its way into US bond funds, which saw inflows of $13bn. Investors had decided quantitative easing was more likely to hurt higher risk assets, while debt market problems were largely reflected in asset prices.
The frenzied move out of emerging markets tempered as February progressed. This was particularly noticeable for emerging market bonds, where the year-to-date outflows of $8bn were substantially lower than the 2013 total of $14bn.
Investors were also willing to revisit developed market equity funds, which reported inflows of $13.9bn during the week. US equity funds recouped some of their losses from earlier in the month.
The ETF market was similarly hurt by the poor sentiment towards risk assets, according to the latest ETFGI survey. In January, global ETF/ETP assets fell by 3.2% to $2.32trn, which included net outflows of $7.6bn.
Again, the weakness was seen across both emerging and developed equity markets. Equity ETFs/ETPs saw outflows of $11.8bn. Despite a better performance since the start of the year, commodity funds also suffered, losing $1.9bn. Fixed income ETFs/ETPs made hay, gathering $2.9bn.
The figures from European-domiciled (as opposed to global) ETFs painted a slightly different picture. It showed developed market ETFs still in positive territory, gathering €2.5bn, but emerging market equities continuing to lose ground, seeing €0.4bn in outflows.
Commodities were similarly unpopular and built on their €10bn of outflows in 2013 with a further €0.4bn in outflows for January. Even the recovery in the gold price did not draw investors back in, with gold ETPs losing €0.4bn over the month. Fixed income was a key beneficiary, gaining €1.5bn over the month.
In the UK, investors kept faith with equity funds, with net retail sales of £464m, but flows were concentrated into the UK and Europe. UK equity funds saw net retail sales of £644m, their third month at the top of the tables.
European equity funds were the second best-selling sector, with net retail sales of £261m. However, global equity funds reversed their long run of popularity and saw their first net retail outflow since November 2011, dropping £81m.
Two other key trends prevailed among UK investors. The first was a preference for mixed asset funds. Platforms such as Novia have commented that this year’s ISA season is increasingly characterised by investors adding money to model portfolios of one kind or another and this was reflected in the popularity of the IMA mixed asset sectors, which saw net retail sales of £213m.
Meanwhile, the Targeted Absolute Return sector was the top-selling IMA sector, with net retail sales of £343m – the highest since December 2009 - and most of this money was moving into the mixed asset funds, such as Standard Life Global Absolute Return Strategies.
But investors had not forgotten about income. Property was the second best-selling asset class, drawing net sales of £232m. In contrast with global and European investors, UK investors did not favour fixed income and £229m left the sector.
Fund managers remain unconvinced emerging markets are starting to show value, with many believing they have further to fall.
Wouter Volckaert, manager of the Henderson Global trust, remains very underweight.
“Emerging markets represent only around 2.5% of our trust, compared to a benchmark weighting of closer to 10%. That said, the sector has underperformed for three years and valuations are getting close to attractive levels. Samsung, for example, currently trades on around 6x earnings,” he says.
“However, I do not think emerging markets have reached a point of real capitulation yet. There are still a lot of questions to be answered about their financial systems.”
He says the discount to developed markets looks higher than it has been for some time but there is more risk around. He has a shortlist of emerging market stocks he is watching closely for the best time to buy.
David Coombs, head of multi-asset investing at Rathbones, also sees little reason to head back into emerging markets.
“There is a lack of visibility on earnings for many emerging market companies and a significant risk of central bank policy errors. We believe the commodity supercycle has come to an end and China is slowing. This is likely to keep emerging market volatility high,” he says.
He has, however, taken selective exposure to mining stocks, believing there is a short-term self-help story in place, but he distinguishes this from commodities, where he still has concerns.
Elsewhere, Coombs remains overweight the US, believing that, on a forward P/E ratio, it still looks better than many other emerging markets. He points to improvements in construction and believes the market offers the potential for upward revisions in earnings. This is now a contrarian view, with many investors backing away from the US on valuation grounds.
Investors now have a decision to make: stick with expensive developed markets, or take a risk on cheaper emerging markets at a time when the risks look significant. The experts are not yet moving back in and Coombs has large cash holdings in his portfolio. Markets, as always, are not offering any easy answers.
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