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Why You Shouldn’t Write Off Emerging Market Stocks Just Yet

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Market Realist – The following is a fund manager interview with Devan Kaloo, Head of Global Emerging Markets Equities team, advising the Aberdeen Global Emerging Markets Fund.

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Emerging markets have enjoyed a good run lately. Why?

There are a number of reasons behind this rally. Signs of improvement in economic activity in China, along with a recovery in oil and other commodity prices, propelled demand for emerging market assets since February. After four consecutive months of outflows, capital flowed back into the emerging markets for four weeks during March. That helped limit outflows in the first three months of this year to US$5.1 billion, compared to the US$68.2 billion that exited this asset class in 2015. A weakening of the US dollar, amid market expectations of less frequent Federal Reserve rate-hikes, means emerging market currencies have regained some lost ground. Any indication that the Fed will further delay the normalisation of US interest rates will be supportive of the current environment.

How sustainable is this?

It would be naive to downplay the severity of the headwinds facing emerging markets. Yet, it’s equally detrimental to be blinded by all the negative sentiment. Rate hikes in the US could still weigh on demand for emerging market equities, the Chinese economy is likely to continue to slow down as it faces various imbalances, and commodity prices could yet see more declines. That said, outside of China (GCH) and the commodities sector, the earnings cycle seems to have bottomed out and thus emerging market companies should deliver reasonable earnings growth this year in local currency terms. Emerging market (FEO)  governments are making more strenuous efforts to support growth through various domestic reforms and infrastructure investment. In the meantime, public and private sector balance sheets are generally robust, so we don’t foresee any major issues with debt. After a few years of slowdown we believe this asset class is much better positioned for sustainable recovery.

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Market Realist – 2015 was a tumultuous year for emerging markets (EEM), to say the least. According to the IIF, emerging market (or EM) assets registered outflows of $735 billion last year. These outflows have slowed somewhat this year with EM equities making a comeback. According to estimates by Bloomberg, outflows from emerging market ETFs last month totaled $220 million compared to the $1.9 billion estimated in the previous period.

We believe that emerging markets (VWO) continue to be good opportunities for long-term investors. This primarily comes down to fundamentals. The contribution of emerging markets to world economic growth has been growing steadily over the years. According to estimates by the IMF, 32% of world economic growth in 2015 came from China while 15% came from India. On the other hand, the US and Europe contributed only 21% (Source: IMF WEO April 2015; Canaccord Genuity). Emerging markets are younger than developed markets (EFA) in terms of demographics, which supports their long-term economic outlooks.

Moreover, a US rate hike might not derail EM currencies, according to Capital Economics. David Rees, a senior markets economist at London-based Capital Economics, recently stated, “Emerging-market currencies have not always underperformed during Fed tightening cycles and we do not expect them to do so this time, even as U.S. rates rise further than is generally anticipated.” As reported by Market Watch, EM currencies remained unchanged in the year following the June 1999 rate hike and outperformed developed market currencies after the rate hike of June 2004. Thus, a summer rate hike by the Fed isn’t likely to uproot the EM rally.

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