In recent years valuations across most asset classes have been sitting in the expensive range. Strong tailwinds from central banks in the form of low interest rates and liquidity support via quantitative easing have largely been responsible for these stretched valuations, while markets have been further fuelled by both strength in the cycle as well as shorter-term positive sentiment.
However, we are currently witnessing a shift in market dynamics as central banks move away from quantitative easing and interest rates gradually move higher from their previous historic lows. Cyclical indicators such as production figures and the output gap are also tapering off and shorter-term sentiment has moved into negative territory. This has resulted in increased volatility in markets and some asset classes retreating from their previous highs.
At the end of 2017 emerging market equities was one of the best performing sectors in the market, with the index (MSCI Emerging Markets TR Index AUD) returning just over 27% for the year. Roll forward one year and the sector was one of the worst performing, with returns of -4.7% as at the end of 2018. The sector has suffered amid concerns of a Chinese slowdown, a strengthening US dollar and other idiosyncratic country-specific issues which have seen large flows out of the sector.
Despite the negative news from a valuation perspective, Lonsec’s proprietary internal rate of return (IRR) model is signalling that the emerging market equities sector is beginning to present value from an absolute as well as asset class relative basis. Our analysis indicates that the valuation support for the sector has continued and the sector now offers a significant premium above developed markets. While risks remain in the sector and the threat of a China slowdown continues to be a topic of debate, in our view the emerging markets sector offers an attractive return premium relative to developed markets, warranting an active tilt to the sector.
Responding to market movements with Dynamic Asset Allocation
Our Dynamic Asset Allocation approach means we can be flexible across asset classes and adjust asset allocation positions for the medium term to navigate market changes. We recently reflected our view of the emerging markets opportunities by making changes to our Multi-Asset and Listed Diversified Managed portfolios and increasing our exposure to the emerging markets sector ahead of developed markets.