After underperforming global markets for the past five years, emerging markets are beginning to catch up.
So says Michael Reynal, portfolio manager at RS Investments. RS Investments sub-advises the Renaissance Emerging Markets Fund.
Following the financial crisis, he notes, “the emerging market rebound underperformed the global market rebound…because of artificially low interest rates in the U.S., and frankly, due to a dramatic break down in the understanding of the cost of capital for emerging market countries.”
Consider that when the U.S. Federal Reserve introduced QE, the cost of capital in the U.S. and Europe dipped, and it’s remained that way over the last several years.
Read: Europe bounces back
Yet, “that hasn’t really had an impact on the emerging market space. Why? Because of perceived risk [and] because access to capital, as cheap as it’s been, remains very tight.”
“So if you’re a mining company in Peru,” he explains, “even though interest rates in the U.S. are low [and] even though you’re likely to fund yourself in [U.S.] dollars, you’re going to have a tough time getting access to that capital [since] liquidity has remained tight in the United States and around the world. The proof is central banks have kept rates very low.”
Now, however, Reynal sees a shift occurring.
First, “we’re starting to see markets planning on an end to these artificially low interest rates,” he says. “Most economists are expecting some form of normalization in U.S. interest rates, certainly by 2015 and possibly before Q4 2014.”
By normal interest rates, Reynal refers to rates sitting above inflation. “People are looking at around 3% in U.S. 10-year treasuries to be an indicator of a normal level of interest rates. If that’s the case, decisions around capital usage would become normal and that would indicate a pickup in the global economy.”
And second, he says emerging markets have offered returns of about 7% year-to-date, while the S&P 500 remains flat. “This is an early sign of a turnaround in emerging market performance.”
Already, says Reynal, “emerging market equities are up about 220%” when you take a 10-year view, “whereas global equities are only up about 120%.” Also, investors can benefit from getting exposure to emerging markets since earnings are currently solid and valuations are cheap.