Outlook 2019: A Map of Emerging Markets

Some of the countries which suffered most during 2018 may prove good value in the future, thinks Delphine Arrighi, manager of the Merian Emerging Market Debt Funds. And Nick Payne, head of global emerging markets at Merian Global Investors, explains how to see through market pricing to discern real value.

Emerging markets have been under pressure in 2018. Uncertainties over the trade war between the US and China exacerbated an already difficult environment. Global liquidity tightened as the US Federal Reserve (Fed) unwound quantitative easing and accelerated the pace of interest rate hikes.

"The stronger US dollar has put all emerging markets currencies under strain despite their relatively sound fundamentals", says Delphine Arrighi, manager of the Merian Emerging Market Debt Funds at Merian Global Investors. Countries with large current account deficits suffered more than others. Argentina and Turkey took drastic measures to curb their macro-imbalances and halt currency depreciation. But even oil exporters weakened, despite improving fiscal and current account balances, as the market ignored the rise in oil prices and focused on fears of a global slowdown.

"Now those fears are spreading across other asset classes and, ironically, could bring about the policy changes emerging markets need to outperform again", she thinks: "Much will hang on the trajectory in 2019 of the trade dispute between the US and China. China has already slowed. If Wall Street and the American economy suffer, Trump will come to the table." Meanwhile, a more divided US Congress would reduce the chance of further fiscal stimulus, which could eventually slow US growth, reprice future Fed hikes and ultimately end the strong dollar cycle.

According to Delphine Arrighi, that could provide the external conditions needed for emerging markets to rebound, as beaten-up valuations and sound domestic fundamentals lure investors back. However, differentiation will remain key because countries with high refinancing needs will struggle in a world of reduced global liquidity.

Discovering treasures in emerging markets
"Long-term investors know a simple secret: there is a difference between market price and intrinsic value. Investing for the long term requires the ability to distinguish between the vicissitudes of markets, which can be as mercurial as the sea, and the firmer ground of corporate fundamentals, which are a sounder guide to companies’ real value and future prospects", explains Nick Payne, head of global emerging markets at Merian Global Investors. He and his team try to seek out firms that have a sustainably high return on invested capital (ROIC), and an economic moat protecting those returns for the future. But that is only one half of the equation. The other is to buy shares in such companies when they are trading at the right price.

"Markets are often swayed, not by fundamentals, but by fear. 'Red October' 2018 is a case in point", he says and adds: "When markets are retreating, an opportunity is given to investors who have studied corporate fundamentals and who have conviction. Like tempestuous seas that cast treasure chests upon the shore, fearful markets tend to offer up sound companies at excessively low prices."

No faith in efficient markets hypothesis
Payne and his team do not believe in the efficient markets hypothesis, an academic theory that claims, in essence, that all information is already in the price, and that all market prices are fair. In fact, they believe that market prices are often far from the intrinsic value of companies. The reason is that markets are driven in part by human behaviour, which is often less rational and subject to psychological biases. Furthermore, some markets are less efficient than others.

"Emerging markets, we contend, are less efficient than those in the US, and can be more volatile than their developed market counterparts. In our view, this gives greater opportunities to investors armed with a firm grip on company fundamentals, and some healthy common sense about market pricing, to invest for the long term in good companies at low prices. Such companies can be jewels in portfolios", Payne argues.