The emerging market outlook is positive for the next 12 to 18 months but the main issue for investors is what the US president might do next in relation to North Korea, according to Hermes Investment Management’s Gary Greenberg.
The FE Alpha Manager said conditions in the emerging markets remain stable with many of the factors that have driven the market rally over the past 18 months holding firm.
Over the last two years the MSCI Emerging Markets index has outperformed the developed market MSCI World index by 14.61 percentage points, as the below chart shows.
Performance of indices over 2yrs
Source: FE Analytics
The manager of the five FE Crown-rated Hermes Global Emerging Markets said: “We have got a world economy that is growing at a moderate rate and emerging markets in general are seeing decent – if not fantastic – GDP recovery and in many cases earnings recovery.
“South Asia looks decent to us, we feel that Latin America has some promise as well and Brazil and Russia are both coming out of recessions so there is this unnatural cyclical recovery going on,” he added.
“I think China is going to continue to try to grow at 5.5 to 6 per cent, Russia is going to continue to meddle in other countries and continue to negotiate as good a deal as it can with energy prices and it is going to remain a commodity producer.
“Brazil is going to come out of recession and hopefully pass the pension reform bill; South Africa is going to muddle along; [and in] Mexico you have an election next year but the market is to some extent discounting that. There is nothing really earth-shattering happening in emerging markets in terms of changes.”
Greenberg (pictured) said the market is currently in the middle of a cycle which has been going up for around 20 months and could run for at least another year and potentially two. 
“One of the forces that brought them down into a bear market for a long time were bad commodity prices, a very strong dollar and corporate profitability was pretty lousy. All of those factors have turned around,” he noted.
However, the rally is contingent on a number of drivers remaining in place, as valuations now look fair value and are in line with the long-term average.
The first is the continuation of growth, which has been a major factor in whether or not the asset class outperforms developed markets.
“When emerging market growth is faster than developed they outperforms and when emerging market growth is slower than developed they tend to underperform,” he explained.
“From 1999 emerging markets started to grow faster than developed and performed like crazy and then in 2011 emerging markets started to underperform.
“That changed about a year and a half ago and the forecast is that emerging markets will perform on a GDP basis a little bit better than developed markets and that should mean that emerging markets from a top down view will continue to outperform.”
Looking at the asset class in more depth, Greenberg highlighted that there are a number of other positive factors in the market.
The first is the fact that wage growth is slowing. While this is traditionally seen as a negative for economics, at a company level this could be a boost to profits.
“You might say wage growth slowing is bad but actually that’s good because it had been increasing a lot and that increase had made it harder for companies to increase their productivity. A slowdown has meant that companies’ productivity has started to increase and that is quite positive,” he said.
Another is the inefficiency of the market, giving active funds such as his own the potential to materially outperform.
“There are areas that are not brilliantly focused. Approximately 7 per cent of investors in Chinese Asia can’t read or write so it makes their stockpicking slightly questionable,” he noted.
Additionally, while valuations are around their long-term average, they remain cheap when compared to those of developed markets.
“Given the volatility of earnings price to book is a good one to look at and the long-term average price to book depending on which period you look at is either 1.45 or 1.7 times,” the manager said.
“We are about 1.7 right now so in other words we are at the long-term average. That’s a pretty good discount to developed markets.”
While the asset class has been on a strong run since the start of 2016, he added that investors should begin to be concerned if this rises to 2.5 times, which he said would indicate a “danger zone”.
As valuations are at fair value however, he said that the performance over the next 12 months is dependent on whether earnings improve.
“For about four or five years ROE [return on equity] has been shrinking in emerging markets but that has turned around now and that is almost all due to an improvement in profit margins,” he Greenberg noted.
This is partly due to the fact that commodity prices have recovered, as the below shows, but also because of the entry into the benchmark of some of the Chinese tech names which are extremely profitable.
Performance of index over 5yrs
Source: FE Analytics
As such, the market saw a 10 per cent ROE last year and is expecting an 11 per cent ROE this year.
“It could go to 12 per cent next year, meaning that the price to book could appreciate and could be around 2 times,” the manager added.
However, while this all sounds positive, there are headwinds, with the biggest threat coming from the US and in particular the increasing rhetoric surrounding North Korea.
“Obviously none of us can really understand what is going on in America. I follow it pretty closely and I certainly don’t understand it and I do see that the big risk actually in emerging markets is some kind of bizarre action on the part of the United States,” Greenberg said.
He added that it depends on whether the rhetoric from US president Donald Trump turns to reality and what actions he may take.
“It’s possible that if China were seen to be even oppositional to the US in terms of North Korea or the US did something militarily to North Korea and China stood up it is possible that a trade war could ensue,” he said.
If there were such a policy misstep, however, this would not only affect the emerging markets but also the US market.
“The US market has been enjoying one of the longest bull markets in history, the recovery is one of the longest in history, so if something went wrong I think people might sell and emerging markets are not uncorrelated unfortunately,” Greenberg noted.
“The US is the big wildcard,” he added, and as such has moved his portfolio mostly into countries that have less external vulnerability.
One area from the US that is being given too much attention however is the Federal Reserve and what impact rising interest rates could have on the emerging markets.
“The Fed would like to believe that the inflation is enough of an issue to raise rates but it struggles with that because there isn’t that much of it,” he said.
“I don’t see the Fed shrinking its balance sheet quickly and therefore I don’t see that as a big problem and I don’t see them raising interest rates a lot.”
He added that emerging markets can take a 100-125 basis point rise in interest rates by the Fed before the liquidity environment gets tougher for them, with only Turkey and South Africa at any real risk in this environment.
Greenberg has run the £1.92bn Hermes Global Emerging Markets since 2011 with deputy manager Kunjal Gala joining last year.
Performance of fund vs sector and benchmark since manager start of data
Source: FE Analytics
Since he took over, the fund has been the best performing fund in the IA Global Emerging Markets sector, returning 76.64 per cent – more than could both the sector and benchmark returns.
The fund has a clean ongoing charges figure of 1.13 per cent.