Frontier economies offer opportunities

Larger emerging markets have underperformed lately, but frontier and smaller developing economies can still offer returns, say Phil Langham, senior portfolio manager, and Laurence Bensafi, portfolio manager with RBC Global Asset Management’s U.K.-based emerging markets team.

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The differential between emerging and developed market growth is still significant. In each of the last five years, emerging markets have contributed to more than 80% of global growth, Langham notes.

“But high debt levels in the developed world have constrained growth, and this will continue over a prolonged period. It’s having an impact on overall emerging market growth,” he says.

Underperformance of some of the larger emerging market countries is likely to continue, Langham suggests. One of the key reasons the BRICs’ performance has lagged some of the smaller markets is that their governments interfere more in their economies.

In Brazil, that oversight is especially pronounced in the banking and utilities sectors. In China, government control of banking and energy markets has been a negative. The Indian government is mired in red tape, and in Russia “the energy sector, a key part of the whole economy, is subject to high taxes and policy uncertainty,” Langham says.

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This level of interference is absent in some of the smaller emerging markets, like Mexico, Peru, Columbia and some Southeast Asian countries. “This is one of the key reasons we’re more positive on these markets,” he adds.

Historically, emerging market earnings yields and bond yields have moved together.

“But over the last two-to-three years we’ve seen the same divergence in emerging markets that we’ve seen in the developed world—bond yields coming down and earnings yields going up,” Langham notes.

This is usually symptomatic of a deflationary environment, like what we’ve observed in Japan.

“Whatever you think will occur in the developed world, that kind of deflation seems extremely unlikely in emerging markets. So over time we expect earnings yields and bond yields to gradually converge, and the most likely way that’s going to happen is a re-rating of the equity market,” he explains.

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Bensafi notes valuations in emerging markets are 29% lower than the U.S. market. “This is one of the largest discounts we’ve seen in a long time,” she says, adding it’s a signal that a re-rating is coming.

Canadian investors are notorious for home bias, partly because they worry that companies in faraway places may not be held to the same standards as ours.

“One key to avoiding problems with accounting anomalies is to focus on something they can’t hide—cash flows,” says Langham.

Another important step is evaluating the corporate governance regimes of companies making the potential buy list. This often means face-to-face meetings with management teams.

“Companies that don’t meet our stringent standards are eliminated,” says Bensafi.

Read: Emerging market bonds defy investor worry