Emerging market equities - a reality check

Emerging market equities - a reality check

Despite their more attractive growth and secular tailwinds, many investors have historically been hesitant to invest in emerging markets (EMs). The reasons for this include concerns around currency volatility, political instability and economic over-reliance on commodities and resources. This view is increasingly outdated, however.


Currency is a zero sum game

One widely held fear is that capital gains made in these markets could be eroded by adverse currency movements.

Yes, global financial flows can reverse very quickly, and interest rate differentials with the developed world play a central role here. However, many emerging market economies have much stronger external profiles (lower current account deficits, larger foreign exchange reserves) than in the past and, significantly, no dollar-pegs left to defend.

In fact, frail balance of payments, which were a key source of the turmoil seen during the Asian financial crisis in the late 90s, are largely a thing of the past. And, while the situation varies from country to country, corporate debt is also increasingly denominated in local currency as opposed to hard currencies such as the US dollar.

These factors cannot guarantee currency stability in the short term, but they tend to serve as an anchor over a longer time horizon. And we shouldn’t forget, developed market currencies are not immune to volatility – as recently illustrated by the gyrations of sterling following the ‘Brexit’ vote in the UK. As chart 1 illustrates, while the amplitudes may be slightly greater in EM, developed market currencies do not move in a straight line either.

 

Chart 1: FX volatility is not exclusive to EM

Source: Bloomberg Barclays, data as at 8/8/2017

 

Levelling the political playing field

Emerging markets are also (perhaps unfairly) still perceived as being associated with excessive political risk, largely due to the turbulence some of these countries have experienced in the past. Although this risk has not disappeared, it should not be exaggerated. Most emerging market countries now have the safety valve of democratic elections and more robust institutions – judicial independence and the rule of law – that provide critical checks and balances. And against the backdrop of recent populism in many developed markets, the policy direction across many emerging markets looks remarkably predictable by comparison.

 

Tech takes the driving seat

The growing economic maturity of emerging markets is illustrated by the diminishing importance of sectors such as energy and materials in driving those economies.

Consider, for example, the rapid rise of areas such as technology and consumer sectors in the MSCI Emerging Markets Index. In 2010, energy and materials accounted for 30% of the index. In 2017, that figure has fallen to less than 14%. Technology, meanwhile has more than doubled from just under 13% to nearly 27% - over a quarter of the index. The combined weighting of consumer discretionary and consumer staples has also grown from 10.6% to 17% over the same time horizon.[1]

These developments are bringing emerging markets more in line with the sector composition of developed markets, which can come as a surprise to many investors because the traditional perception of emerging economies as being largely commodity- and resource-driven still exists.

In reality, this view is out of date. Today, many emerging market countries are at the cutting edge of technological innovation, reflected in the fact that the MSCI Emerging Market equity index actually has a higher weighting in technology than the developed markets (27% for the MSCI Emerging Markets index versus 16% for the MSCI World as at 31 July 20171). From IT services in Eastern Europe and India, to online platforms in China and IT hardware in Korea and Taiwan, many emerging market companies are leading the way. In some cases they are leaving developed market companies in their wake.

So, today, when investors are thinking about emerging markets, they should be thinking about technology, world-leaders and economic growth.

 

[1] MSCI sector weightings as at 31 July 2010 and 31 July 2017 for MSCI Emerging Markets index and MSCI World.

 

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