Emerging markets have come full circle. Having been out of favour in the late 1990s, when currency...
Emerging markets have come full circle. Having been out of favour in the late 1990s, when currency crises in Asia and debt defaults in Russia spooked investors, the asset class finds itself back in vogue.
Emerging economies have historically been big borrowers of external capital to finance their growth. In the first half of this year, the heavily indebted economies in Latin America, Asia and Eastern Europe were the biggest beneficiaries of the global environment of low interest rates as investors searched for yield.
The Bank of International Settlement observed this earlier in the year as inflows into emerging market debt funds reached record levels.
Strengthening exchange rates related to these capital flows have given central banks around the emerging world the flexibility to cut rates, a positive trigger for equity markets.
Boosted by unprecedented fiscal and monetary stimulus, the world economy is showing early signs of recovery. Emerging market equities traditionally deliver their strongest performance as global growth expectations start to rise in an environment of low interest rates.
In previous business cycle recoveries, this has led to absolute returns in the region of 80%-90%, a lot more than the 35% returns the asset class has experienced since the October lows.
Within emerging markets, Asia has the potential to be the star performer. It benefits from a high sensitivity to global industrial production and any pick-up in leading indicators.
This effect is particularly exaggerated in this cycle as the robust performance of the domestic Chinese economy underpins demand in the region. Valuations within Asia remain particularly appealing. Asia's dividend yield and P/E are currently at levels last seen in the late 1990s crisis, yet the economies are in a much healthier state than they were during that period.
Of particular note is the fact Asian short-term rates have fallen below the region's dividend yield. This should represent an important trigger for stocks in an environment with a healthy range of earnings upgrades.
While all this is positive, the risks of investing in emerging markets have not disappeared and political concerns may still play on the minds of the faint-hearted. Elections in many nations over the coming months could change the investment climate of the markets concerned.
However, while emerging markets have had a good run so far this year, there is little, if any, evidence of the economic imbalances that have plagued the asset class in the past. Economic growth across the emerging market universe has been robust in the past couple of years, industrial activity is picking up and the emerging countries are gaining market share in world trade.
The recent rallies in emerging financial markets and improvement in the countries' economies should begin to attract significant flows of foreign investment, providing a further tonic for emerging market investors.
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