Will emerging market woes continue?

For much of 2013 the world's big stock markets had a spring in their step, with America's main index, the S&P 500, and Japan's Nikkei 225 leading the way, with gains of 30% and 57%* respectively. However, the story in emerging markets was somewhat different, with the sector posting a loss for the year, and some markets seeing steep declines, with the MSCI Brazil, for example, down more than 20%*.

The reasons behind the decoupling of developed and emerging markets are well understood: Ben Bernanke's “tapering” comments spooked markets which in turn exposed the structural flaws and current imbalances of several emerging market countries, in particular the “fragile five”, which consists of Indonesia, South Africa, Brazil, Turkey and India. We initially commented on this issue back in July, suggesting that, for long-term investors, the sell-off may have represented a buying opportunity. As it turns out, the sector did see further modest declines since then, but I believe our original thesis remains intact.

I, for one, think emerging markets are cheap, with some, like Russia and Brazil, looking exceptionally so. However, there are reasons that they are trading on low valuations and those reasons are not going to disappear overnight. Also, I find it hard to think of what the catalyst might be for sentiment to change and making accurate macroeconomic forecasts is notoriously difficult with few, if any, industry experts able to do it on a consistent basis.

So, what does this all mean for the UK retail investor? Well, we know that emerging markets are relatively cheap, at least compared to recent history but, given that we are unsure how long this may go on for, it leaves investors in a tricky situation. The way I see it is that if you believe in mean reversion you have two choices: You can wait for visible signs that sentiment has changed and look to jump on the rally. But this has two potential problems. Firstly, it is hard to gauge accurately when sentiment has changed; after all, it is not as if someone jumps out from behind the sofa to give you the thumbs up when everything is ok! Also, as markets are forward-looking, if you wait for the visible evidence to materialise you may well miss the juiciest part of the rally.

Another option is to start building up a position via a regular contribution. This will allow you to take advantage of pound-cost averaging; when fund prices are volatile this helps you get a better average entry price, as you buy more units when prices are lower. To give you a real life example if you had bought and held the emerging market index at the start of 2013 and held for the year, you would have, somewhat unsurprisingly, lost money. However, if you had bought the same amount, but spread over 12 equal payments, you would have made money over the course of the year.*

I realise what I'm saying here isn't reinventing the wheel, but I'm sure there are some of you out there pondering when to get back into emerging markets, and my argument would be you're better off not trying to time the market and a regular contribution will ensure you don't miss the eventual rally, whenever that may be. Also, if you already have an allocation to emerging markets and have taken all the pain of the last 12 months, I would be inclined to stick with it, as I suspect we are nearer the bottom than the top.

By Harry Driscoll, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Harry’s views are his own and do not constitute financial advice.