Investments  

The emerging markets look an attractive option

This article is part of
Hunt for Income - November 2014

The current environment is reminiscent of the so-called ‘taper tantrum’ of May 2013, when then Federal Reserve chairman Ben Bernanke’s suggestion that quantitative easing would at some point taper off triggered dramatic volatility in currency and equity markets.

Investors at the time speculated that a tightening of US monetary policy would trigger economic dislocations, particularly among emerging market economies.

Emerging market currencies remained under pressure for the rest of 2013 and did not stabilise until the Federal Reserve began to reduce quantitative easing late in 2013 and emerging market economies demonstrated resilience.

Article continues after advert

We may again have to see the Federal Reserve hike rates before the uncertainty and negative sentiment lifts.

However, it is important to remember that the reason US monetary policy is tightening is because of consistent evidence of a US recovery, and it is hard to imagine that a sustainable recovery in the world’s largest economy is a negative for equities anywhere.

The US consumer remains a key driver of global demand and an improvement in spending power will be felt particularly strongly in export-driven emerging markets such as China.

This is why, over the long term, emerging markets have tended to outperform during periods of rising US interest rates, as rising rates are typically driven by accelerating economies. And when economies accelerate, more cyclical companies – which are prevalent in the emerging markets – tend to outperform.

The unique nature of the current post-crisis cycle and the use of unconventional monetary policy has led to a consensus that expects a different relationship between emerging market equities and US rates during this cycle. But it begs the question: if the US slid into recession, would that be a catalyst to buy emerging market equities?

Equities continue to offer levels of income generation that compare well with the alternatives.

The asset class still offers the potential for a rising income stream, as well as some protection from inflation, since equity dividends tend to grow faster when inflation accelerates.

The vast gap in valuation between the US market and emerging markets remains in place, making the latter look particularly attractive as it is fairly clear where earnings and dividends will grow fastest over the longer term.

With the US high-yield bond market showing signs of strain in recent months and the level of stock buybacks from US companies beginning to fade, investors can feel increasingly confident in modest exposure and a defensive skew within the US.

Pat Ryan is a manager on the Lazard global equity team