Is it the right time to invest in EM equities?

In recent years, emerging markets have attracted significant attention from investors due to their increasing share in global economic output, stock market capitalization, favorable demographics and high economic growth expectations. Emerging markets are the developing economies with rapid growth and industrialization. These countries possess securities markets that are progressing toward, but have not yet reached, the standards of developed nations. Emerging markets typically have fewer and smaller publicly traded companies than developed markets. However, the securities markets in the developing world are also characterized by lower liquidity, less regulation, and weaker accounting standards than more mature markets such as the U.S., Japan, and many countries in Europe.

Why consider Emerging Markets for Investment

Emerging markets attract investors for various reasons including fast rapid economic growth, favorable demographics, growing consumption potential and offers a healthy investment diversification. Although emerging markets have been relatively more volatile than developed nations, particularly US, exposure to these markets can actually decrease overall volatility when returns of individual holdings diverge. Emerging markets have a potential to emerge as a solid investment avenues with an above-average returns on investments driven by comparatively better earnings growth.

Historical performance of Emerging Markets

Emerging markets have disappointed investors in recent years mainly on account of weaker commodity prices, sluggish exports and political instability amongst others. The corruption scandal in Brazil, China’s slowing economic expansion (GDP slipped from 7.3% in 2014 to 6.9% in 2015) and the oil-induced recession in Russia added to the woes of investors. Over the last five years, the MSCI Emerging Markets index, which tracks the stock markets of developing nations, has provided negative annualized returns of -4.7% as against a 12.3% annualized returns for S&P500. However, the long term returns since 2003 tell an altogether different story as the MSCI Emerging Market index has outperformed S&P500 index by ~200 basis points to fetch annualized returns of 11.0% by the end of 2015.

In 2016, the continued downtrend of emerging markets performance since 2011 has reversed as the emerging market equities have rallied 15.5% YTD this year, outperforming the S&P500 by 7.4%. The world’s foremost emerging markets – Brazil, Russia, India and China (BRICS) have recorded positive returns till date with the two cheapest and most hated Emerging Markets, Brazil and Russia topping the list. With 63.1% YTD returns, Brazil appears to be a clear winner among the emerging markets signaling the easing of political instability in the country. India, with better investment sentiments, generated 7.8% returns followed by 6.9% returns by China. Investors believe this positive reversal will continue for the next few years backed by the stabilizing commodity prices, recent developments in India and China along with easing political instability in Brazil, offering a potential buying opportunity.

Weaker dollar and dovish interest rate environment bodes well for the EM equities

The weaker dollar helps the movement of emerging markets as the performance of emerging markets is inversely proportional to the dollar index. Historically, many factors including strong geopolitical forces and higher interest rates in the US have led to the relatively stronger dollar as compared to other currencies, especially emerging market currencies. The US dollar index closed at $96.02 as on Aug 31, 2016, down 2.6% YTD. The Federal Reserve recently kept its benchmark rates unchanged in response to sluggish job creation in preceding months and discouraging economic data resulting in the weakening of dollar index. Amongst the emerging market currencies, Brazilian Real has appreciated 18.3% YTD, followed by Russian Ruble (10.5%) and South African Rand (5.0%) while Chinese Renminbi and Indian Rupee have depreciated by 2.8% and 1.2% respectively.

 

Going forward, the emerging markets tend to benefit provided the world’s major central banks continue to maintain their dovish stances on key benchmark rates. The markets seems of the view that the US Federal Reserve will keep rates low in the short term and may not ever raise them back to historical norms thereby helping the asset classes that benefit from low interest rates. An environment of negative yields also forces investors to rebalance their investments in asset classes from fixed income securities to equities in search of higher yields. Therefore, we expect emerging markets to continue to see growing interest, as US fixed-income investors seek higher yields overseas and equity investors expect capital to continue flowing into emerging economies.

India appears to be well positioned to benefit from the capital flows to emerging markets

India is one of the fastest growing economies in the world with expected GDP growth of 7.6% for FY2016-17 as against the 2.6% growth of world economy as cited by World Bank. The country is well positioned to achieve the targeted growth on account of improved governance and streamlined tax regimes, good monsoon, an acceptable range of fiscal deficit and improved investor sentiments after introduction of BJP Government led by Prime Minister Mr. Narendra Modi. 

Among major emerging market economies, India's growth is the highest and the Indian rupee has been a relatively better performing EM currency in the last few years. India has recently outpaced China as the world’s fastest growing economy and is expected to maintain the lead for the next few years as India’s emerging market counterparts are projected to grow at relatively slower pace. After recording 6.9% growth rate last year, the lowest in last two and half decades, China is expected to grow relatively sluggishly at 6.7% in 2016. Brazil and Russia are expected to continue facing deeper recessions given the plunge in commodity prices and weak oil revenues while South Africa is expected to grow at 0.6%. 

India seems to relatively insulated from the aftershocks of Brexit as it has lower export dependency on Britain as well as fiscal and monetary flexibility following improving fiscal deficit situation and rising foreign exchange reserves. This positive optimism is evident from the 17% CAGR in the cumulative investment inflows (both debt & Equity) in India in last decade. The FPI investments till Aug 2016 this year were recorded at INR335.01 billion.

The quality of governance is also improving quite dramatically after the Narendra Modi led BJP Govt came into power with majority in 2014-15. It can be evidenced by introduction of measures like the Bankruptcy Law and the Land Acquisition Bill, easing the norms for FDI, cleaning up the Indian banks' balance sheet, commitment to recapitalization, and streamlined tax regime with the introduction of uniform Goods and Service Tax (GST). The Government is committed to improve business environment in India by implementing a stable, predictable and congenial tax regime. This would help improve India’s current 130^th ranking in ease of doing business.

Demographically, India has the youngest population in the world with median age of 27 yrs, compared to 37 in China, 38 in US, 41 in Europe and 46 in Japan. More than one third of India’s current population (1.3+ bn) is aged between 15 and 34 years, out of which half of the population is aged at 24 yrs. Over the next five years, India’s population is expected to grow by 1.4%, as against 0.5% growth in China, 0.9% growth in US and 0.3% growth in Europe.