The case for emerging markets
Higher economic growth in emerging markets means they remain attractive to investors.
Last year, as economic growth rates across much of the globe were increasing in concert and the US dollar was stuck in a downward dip, there were capital flows into emerging markets (EM) and robust performance from many EM assets, with equities advancing strongly. Even heightened bouts of geopolitical discord seemed only to dent markets temporarily as they bounded higher for much of the year
As Emerging Market countries expand, so too do their businesses
The EM investment case
The higher growth rates produced by many EM countries and companies make them attractive to investors. Currently, India, China, Thailand and Indonesia, for example, have year-on-year gross domestic product growth rates that sit firmly above the levels seen in most developed markets. As EM countries expand, so too do their businesses, providing many interesting investment prospects. Additionally, increasing standards of living should, over time, lead to a broader and more affluent consumer market for companies to serve.
The case is further boosted by the potential for market-friendly measures such as social, regulatory or political reforms, which in turn bring increased confidence in a market over the long term. Given that emerging-market equities have tended to trade at a discount to more developed markets, there’s often a valuation case for the asset class. In addition, accessing EM equities as part of a multi-asset fund may provide the opportunity to increase risk-adjusted returns across a portfolio over the long term, as these assets can bolster portfolio performance while reducing investment risk through diversification.
In the first half of 2018, perceptions of the investment environment turned swiftly. Although US interest rates were on the up through 2017, expectations shifted towards an increased pace of rate hikes, as agreement on a large tax cut and strong inflation in the United States surprised market participants. At the same time, there were hints other major economies may be slower to raise rates than previously thought (including the UK), leading to a rebound in the performance of the US dollar. In turn, this caused EM equity performance to weaken. This was despite a continuing backdrop of generally robust economic growth forecasts for emerging countries and, in our view, a relative EM equity valuation discount compared with developed markets. Ongoing news flow surrounding protectionist moves by the US government also took its toll on markets, particularly in emerging regions, in the first half of the year.
A rising US dollar can be a problem for emerging markets. First, it increases the cost of repayment of US dollar-denominated debt, so loan servicing can become a greater burden. Many EM sovereigns and corporates borrow in foreign currency, especially US dollars, because of limited domestic capital pools and cheaper dollar-funding costs. Second, capital flows shift and in the first half of the year some market participants pulled funds from emerging markets. The last time we saw something similar was the so-called ‘taper tantrum’ of 2013, when EM investments fell back heavily on the expected phasing out of US quantitative easing. The last 18 months have also seen a strong bounce in crude oil prices which could amplify the problems for some EM countries, particularly the net energy importers.
We see many countries making positive moves to tighten finances, bolster investment or take anti-graft measures, while also producing strong economic growth.
The emerging markets that struggled in the first six months of the year included some that have been more exposed to shifting investor sentiment because of domestic issues. Several countries run chronic budget and/or current account deficits that can suddenly prove difficult to finance when investor confidence weakens. Argentina is a case in point. Earlier this year it had to ask the International Monetary Fund for support after three rate hikes in just one week (from 27.5% to a whopping 40%) failed to stem capital outflows.
A rising US dollar can be a problem for emerging markets. First, it increases the cost of repayment of US dollar-denominated debt.
A number of countries have weak institutions and policy-making frameworks that undermine investor confidence in their ability to manage shocks. For example, the Turkish lira has been under severe pressure as the country’s president, after calling a snap election in June, questioned the need for the central bank to raise interest rates to help curb inflation. The subsequent standoff with financial markets and a diplomatic dispute with the US has seen the currency drop by 40% this year. Others have domestic or external political risks, such as concern over corruption (e.g. Brazil or Malaysia) or Russia’s incurring of international sanctions. Some have elements of all these risks.
A number of countries have weak institutions and policy-making frameworks that undermine investor confidence in their ability to manage shocks.
Many EM sovereigns and corporates borrow in foreign currency
A place for EM investments in multi-asset portfolios
However, taking a broader view and looking at the range of markets across the EM investment universe, we see many countries making positive moves to tighten finances, bolster investment or take anti-graft measures, while also producing strong economic growth. While specific countries are grabbing headlines at the moment, we believe that the many positive aspects of the EM equity investment case should return to the fore in time.
We believe that the long-term potential for EM investing is strong. And, although market gyrations are to be expected in emerging countries (as experienced in recent months), the influence of such volatility can be mitigated by diversification across a range of asset classes, styles and regions. Additionally, if individual EM funds within a multi-asset portfolio are well-diversified across many different markets, as with the EM equity funds in our portfolios, then country-specific risk is mitigated. At Scottish Widows, EM equities remain an important element in our multi-asset funds.
Andrew Colquhoun | Senior Asset Allocation Manager
Investment markets and conditions can change rapidly and, as such, the views expressed in this update should not be taken as statements of fact nor be relied on when making investment decisions. Forecast are opinions only, cannot be guaranteed and should not be relied on when making investment decisions.
We believe that the long-term potential for E.M. investing is strong