Bringing it back home: Developed investors and emerging markets

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Emerging market stocks and bonds have underperformed sharply as monetary normalisation has loomed.

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Emerging stocks, in particular, had already lagged considerably, and this has really gathered pace in 2013. Inclusive of currencies, they have now given back all of their outperformance against developed markets since early 2009.

This underperformance has not been a surprise, though in retrospect we should have been underweight emerging markets in a balanced portfolio, not simply neutral. We’ve long had a tactical preference for developed stocks and bonds, not because we lack faith in the long-term emerging market story but because we’ve felt investors have been overly pessimistic about the developed world. Meanwhile, some emerging market advocates were acting more like cheerleaders than analysts of late. Investment is not immune to fashion and fads.

The prospect of higher bond yields and interest rates in the US and Europe has now had a catalytic effect, triggering portfolio outflows as developed world institutional investors have had second thoughts about their easy “carry” trades, and have either taken a profit or simply given up on them to bring funds back home.

“Monetary normalisation could keep emerging markets under pressure for a while yet”

We doubt this process has yet run its course, even though the relative valuation of emerging equities at least is now starting to look attractive. The local performance of several prominent emerging economies has disappointed – and we’re not thinking of China, whose market has shared in the relative weakness but whose economy is doing pretty much what it was expected to. Rather, countries such as Brazil, India, Indonesia, South Africa and Turkey have been running large current account deficits that have left them dependent on external financing precisely at the time when that financing is less forthcoming, and sharply weakened currencies have compounded their poor local currency performance.

We do not think emerging markets’ current underperformance will develop into the sort of rout seen when they last fell out of fashion in the mid-1990s; policies and balance sheets are more credible. At some stage, as in the developed markets, the modestly improved prospects for US and European growth that we think are fostering monetary normalisation will give some emerging markets a boost. With their currencies now at more competitive levels, they could rally vigorously. But perhaps not just yet.