Opportunities amid the turbulence

Key markets worth watching include, South Africa, India, Indonesia and Brazil.

Public policy is often what defines the economic and investment potential of an emerging market.

Take the Korean peninsula – 60-odd years ago, a single country was divided in two. The North adopted a closed Communist-style mix of policies while the South chose an educate-export-integrate model. Two generations later, the South is roughly 17 times richer per capita than the North.

Policies are the direct result of political trends and this year marks one of the busiest election years in emerging markets. Voters head to the polls in more than 40 countries that account for 20 per cent of the world’s global output. Key markets worth watching include, South Africa (April-July), India (April-May), Indonesia (July) and Brazil (October). These countries represent about 40 per cent of emerging market bond indexes and more than 25 per cent of the equity indexes.

What makes these elections important is that amid the global economic sluggishness we may see political shifts that could provide clues to future trends. Compared with a decade ago, most countries are now facing economic headwinds .

Amid higher US interest rates – now about 80 to 100 basis points higher than the lows – the external environment is becoming less favourable and foreign investors have been shying away from emerging markets.

On the equity front, many institutional investors have quickly reversed their sentiment on emerging markets. Flows have reversed in the past year.

Politicians in these countries are between a rock and hard place. On one end are foreign investors (who often shape the tone for emerging market returns) demanding often incongruous reforms to curb inflation and stimulate growth. On the other, pressures from rising local middle classes demanding more and better public services.

These local pressures are exacerbated by forces from the world’s two largest economies, the United States and China. Impatience is mounting as external factors, primarily China’s slowing growth and tapering by the US Federal Reserve, have led many investors to notice some structural vulnerabilities of select countries that failed to tackle meaningful reforms in the years leading up to 2008.

Despite the recent sell-offs and political unrest this year, none of the leading emerging markets is close to the solvency crises of the mid-1990s. As such, many politicians may not feel the urgency for quick reforms. So investors may not see a noticeable change in policy direction.

In the meantime, emerging market assets look attractive relative to valuations.

JPMorgan notes that emerging market speculative and non-investment grade BB bonds actually pay more than highly speculative US industrial single B rated instruments, and emerging market investment-grade bonds pay roughly double what you would earn for similarly rated US industrial bonds – about 260 basis points over US Treasuries versus 130 basis points.

On the equity side, emerging market stocks are now trading at a discount not reached since 2004 and 2005, while the US and European markets are trading at a PE of roughly 16, emerging markets are down to about 10.

Headlines have been ugly for emerging markets this year. China’s sudden slowdown; protests in Egypt, Turkey and Thailand; and the Crimea crisis. The election cycle only stokes such headlines, making it tough for investors to separate the signal from the noise.

But keep in mind that fundamentally, these markets are very different from a decade or two ago. With relatively low inflation, more productive workforces, US$8 trillion in hard currency reserves and growth rates still ahead of the US and Europe, most emerging markets are in better position to cope with the sluggish environment than before.

Investors who accumulate risk assets such as emerging markets when they are out of favour are often handsomely rewarded over time as sentiment gives way to fundamentals and valuations. This may be an interesting year to add such assets.

Peter Marber is the head of emerging market investments at Loomis, Sayles & Company