We are now used to analysts’ opinions to invest in emerging markets (EM) from time to time, and we are possibly at it once again. The calls are coming as the US Federal Reserve (FED) seems to be considering an interest rate cut. This is due to the fact that the US economy has slowed and helped convince the FED to turn dovish, not just by bringing the continuous rate hikes to a halt but to also possibly consider a rate cut. 

Theoretically, as dollar-based investments start yielding a lower level of interest, currency outflows could take place in favour of those offering higher interest rates, particularly in the developing world. This phenomenon is known as ‘carry trading’.

Performance of EM assets tends to be inversely related to that of the dollar interest rate for another reason; namely, a lower interest rate could imply a weakening dollar and given that most EM companies borrow in dollar, their expenses decrease as their profitability improves.

EM or developing countries are nations which are focusing and investing in more productive capacity. This means that such countries are moving away from their traditional economies that relied on agriculture and the exportation of raw materials.

Guy Miller, chief market strategist at Zurich, says he is not particularly keen on EM assets at this point in time, especially due to the reigning uncertainty in investment markets, primarily due to the ongoing trade disputes. 

EM perform less well in periods like these, he said, and believes that negatives are currently outweighing positives. 

On the contrary, according to Mike Ryan, chief investment officer for the Americas at UBS Global Wealth Management, the dollar is probably at its peak against a number of EM currencies and thus believes that there is a cluster of such currencies that will look more and more appealing.

It has been a very positive year so far for EM equities – up 10.6 per cent year to date, of which only 0.6 per cent in the second quarter. Same goes with EM debt, which registered an almost 10 per cent year to date return. Unsurprisingly, this performance was registered on the back of a dovish tone by the US FED and overall subdued volatility over the period. 

Tensions in the geopolitical environment, particularly the US actions on trade in May and early June led to a certain level of uncertainty that was driven by the fact that these geopolitical tensions do not seem to reflect a consistent strategy and could only be designed to obtain leverage in negotiations and to increment populist support. 

It is also worth noting, that the subdued returns of just 0.6 per cent in the second three months of the year were also due to greater outflows from EM in favour of safe haven assets like the dollar, Swiss franc, Japanese yen and gold.

Despite these stumbling blocks, the majority of global growth will likely come from EM, particularly due to the stimulus in China. China’s economic growth rate has experienced a prolonged decline, as the government’s main objective is that of having a more sustainable economy. However, following the initiation of the trade war with the US and the uncertainty that this brought along, in June, the Chinese finance ministry eased restrictions on local governments that raised money via special bond sales. 

EM and developed markets tend to be highly uncorrelated over multi-year periods

This move triggered governments to increase their spending on infrastructure projects and the real GDP growth of 6.4 per cent, in the first quarter of 2019, exceeded expectations. 

The relatively higher volatility levels experienced by the EM asset class makes it easier to mask the intrinsic value of investing in it. Fundamentals in EM countries remain relatively sound with balance sheets having become steadier than expected and fiscal deficits, generally, in good shape. Interest rates are also substantially higher compared to those of developed markets. 

This, together with the fact that EM growth is predicted tobe the main catalyst of global growth, reinforces the idea that the presence of EM assets in a portfolio of assets is desirable and could yield optimal investment returns.

It is fully understandable that a decade of poor returns makes EM not popular. However, over the longer term, EM have performed relatively well and enhanced diversification levels of portfolios. This is because EM and developed markets tend to be highly uncorrelated over multi-year periods. 

For example, US stocks yielded zero returns in the period between 1999 and 2009, while EM practically tripled in value. The exact opposite was then registered in the following decade where the strength of the dollar has reduced the returns for EM stocks by three per cent annually.

The outperformance of the US market over the past decade can be attributed to clear but probably temporary factors. The historically low interest rates, the strong dollar and the low level of initial valuations 10 years ago are some of these. 

Although it is impossible to predict what the future stores, the relatively low valuations, the weakening dollar brought about by potential interest rate cuts and a relatively high GDP growth could see the EM in an optimal position to outperform.

The difficulty in predicting what is in store and given the number of currencies and economies falling under the EM sphere, exposure to this asset class can be best attained via investment in collective investment schemes that are not exposed to singular EM currencies or economies. 

By so doing, the likelihood of experiencing greater investment returns while keeping volatility and default risk under control is definitely not a utopia.

This article was prepared by David Baldacchino, MSc Wealth Management (Edinburgh), B.Com (Hons) Banking and Finance (Melit.), DipFA, is investment advisor 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 2122 4410 or e-mail david.baldacchino@jesmondmizzi.com. www.jesmondmizzi.com