“There are two pushbacks [on EM equities] from institutional investors. The first one is China,” he told FSA. “The second one is that the US is entering a tightening cycle. We disagree on both.”
China is considered the biggest risk for emerging markets, he said. Still, “we are more constructive than worried.
“China has problems, but it has the means and resources to manage the problems.” China’s total investment in stocks and assets in the rest of the world, minus the liabilities, equal about $2trn, he said. Coupled with a current account surplus, China has enough wealth to handle the potential risks to the economy.
“When you have these kind of resources, you can manage shadow banking and the need to recapitalize the banks. It’s more or less under control.”
Other pressing concerns have been related to the corporate debt problem, overcapacity in industrial sectors and further depreciation of the currency.
Menges, a client portfolio manager, said that the currency risks of the fund’s China investments are hedged, with the costs at about 2%. The renminbi is still not freely floated, and there is no reasonable clarity about the currency’s direction, he explained. The hedging costs are also significantly cheaper than other EM currencies such as the Russian ruble and the Brazilian real.
Rate hike impact
Menges said an interest rate increase in the US is not directly linked to emerging market currencies and equities.
For instance, during the US tightening cycle between June 2004 to August 2006, both EM equities and currencies still experienced growth.
He believes emerging market equities are turning around thanks to economic growth expectations and comparatively cheap valuations.
Capital inflows into dedicated EM equity funds reached nearly $10bn in July, the largest monthly flow since 2008, according to data from EPFR and JP Morgan. However, the cumulative inflows from January 2008 to July 2016 are close to zero.
The price-to-book ratio of the MSCI Emerging Markets Index stands at roughly 1.5 times, while that of MSCI World Index is at 2.1.
Emerging markets gained 3% in August, leading to 15% cumulative returns since the beginning of this year.
According to FE Analytics, LO’s Emerging High Conviction Fund underperformed the benchmark over the past three years.