Emerging Markets have overtaken developed markets in world output and their share is only forecast to increase. Read here about the potential opportunities investors may find in them and how an unconstrained approach may help.
Emerging Markets (EM) did not use to be for faint-hearted investors. In the 1990s investors experienced balance of payment crises in many Asian countries, double-digit inflation rates in Brazil and Chile and the Mexican Tequila Crisis. Twenty-five years later, these countries have stabilised and converged towards developed market fundamentals and this stability has aided growth. EM and developing economies now account for 59% of the world’s Gross Domestic Product (GDP), and rising, while Advanced Economies’ share has dropped to 40% and falling – see Chart 1.
Chart 1: Emerging Markets: taking over the world (% of world GDP)
Source: International Monetary Fund as of 20 Feb. 2018. The dashed lines indicate the figures are estimates. Please find definitions in the disclaimer.
This growth has made professional investors look differently at the asset class and explore the long-term investment possibilities, rather than seeing it as a tactical, short-term opportunity. Professional investors are also attracted to the variety within the asset class, which offers additional sources of return, for example local currency. EM investing started with mostly US dollar-denominated bonds, but as their central banks demonstrated increased credibility and their currencies became more stable, the international investment community were more willing to invest in local currency bonds. This meant that investors could benefit from any gains offered by the bonds and also from any upside in the local currency. As the local EM government bond asset class grew and matured, EM companies were able to increasingly access the US dollar bond market. This allowed international investors to select more precisely which industry in each specific country they wanted to invest in.
Investments in EMs can benefit from the following positive fundamentals and tailwinds:
1) Global growth: EMs traditionally benefit when global growth is strong as they export goods and commodities that developing nations consume. Ten years after the 2007-08 financial crisis, world economic growth has started to finally pick up in a synchronised manner, which could be a tailwind for EMs going forward.
2) Weak US dollar, stronger EM currencies: Investors can benefit from currency appreciation in local currency EM denominated debt.
EMs are increasingly issuing more local-denominated debt in order to be less dependent on foreign exchange swings. There is still much debt issued in US dollars, but this type of debt makes EMs sensitive to a potential rise in the dollar, which would increase the cost. In the short to medium term, however, some investors see the US dollar on a downwards trend, given the divergence in growth rates between the US and the rest of the world, as well as the rising trade and budget deficits of the US. The stronger growth backdrop for EMs should benefit their currencies.
3) China: Already the world’s No. 1 economy, China’s dominance is only forecast to increase: according to the IMF, China’s share of world GDP will rise to 20.5% by 2022, up from 18.7% now, leaving the US share at 14% by 2022, down from 15.1% now.
China has overcome many investors’ fears that it would not be able to sustain the fast-growth rates of recent years. Fears persist over rising debt and higher labour costs, but the government is taking steps to address this. So, credit limits have been imposed to curtail excess leverage, a shift towards domestic consumption has been incentivised to help the country become less export-dependent, while the currency is increasingly allowed to trade more freely in international markets, joining the International Monetary Fund’s (IMF) elite club of reserve currencies.
4) Real yield: Some EMs, such as Russia and Brazil, have become more disciplined in their fight against inflation, bringing it down to levels not seen in years. Meanwhile, strong GDP growth has helped drive up real yields. This has happened while developed market real yields have remained at negative levels. As shown on Chart 2, the difference between EM and developed market real yields is now at almost a decade high.
Chart 2: Real yields show EM investors get more bang for their buck
Source: Western Asset as of 24 January 2018.DM is developed markets; RHS is right hand side; bps is basis point. Please see disclaimers for definitions.
5) Interest rate direction: The central banks of countries that have been able to control inflation by raising the cost of borrowing now have room to cut interest rates. Some, such as Brazil and Russia, have already lowered their key rates, yielding investors positive returns. In this sense, EMs could now become even more attractive, especially since some developed markets, such as the US, Canada and the UK, have already started raising rates following a decade of monetary expansion.
6) Less dependent on commodities: Emerging economies are becoming less dependent on oil, gas or agricultural products, as they steer their growth towards domestic consumption and services. It is now not unusual to see some leading EM currencies or bond markets continue a positive trend, even in the midst of a global oil sell-off.
7) Demographics: While developed markets scratch their heads over who will pay the pensions of the large baby-boomer cohort, Emerging Markets enjoy a growing working-age population that will help sustain growth rates. According to the World Bank, developed markets’ working age population has fallen from about 67% to 66% over the past 20 years, while that of EMs has increased to 65%, from 61% also 20 years ago.
Chart 3: Trend reversal? Developed market rates go up, EM’s, down
Source: Bloomberg Barclays as of 14 Feb. 2018. The lines show the leading policy rate for each country. RHS is Right Hand Side. Please see disclaimers for definitions.
Emerging Markets are not short of risks, including the potential of an unexpected global risk-off sell-off or a sudden political development unfavoured by the investment community. This is why an active manager, who understands and can decipher the fundamentals behind EM countries or companies, is paramount to identify opportunities within local and US dollar-denominated sovereign debt, as well as corporate bonds.
Managers willing to make a profit in the sector need a profound understanding of the technical characteristics of EM markets, including liquidity and supply and demand issues. In this way active, professional execution can help investors access the opportunities offered by this emerging asset class.