Asset Allocation

Investors typically have on hand a long list of concerns arguing against investing in emerging markets. These concerns often centre on the ability to regather capital once invested, the extent of government intervention, the ranking of investors’ interests and rights, issues of corporate governance, as well as the inherent volatility likely to be experienced in emerging markets.

This month, we argue that these concerns are not insurmountable, particularly compared with the increasing benefits of a long-term strategic exposure to these markets. These benefits include much faster economic and population growth (particularly for millennial consumers) and greater exposure than anywhere in developed markets to many ‘new world’ themes. Importantly, emerging market equities also bring diversification benefits, with a significantly below-average beta (or correlation) to other equity markets. This is a key strategic (and also tactical) advantage as we negotiate the later stages of this extended economic and market cycle.

Tactically, we began moving our portfolios overweight emerging market equities in late September 2018. The 2018 tariff dispute, less synchronous global growth, higher oil prices and a rising US dollar had all contributed to a sharp correction in emerging market equities and value was appearing. Emerging market equities have materially outperformed from the December 24 lows by 600 basis points (bps)—we added to this position in February.

Of course, not all emerging markets are created equal, and the fragility of countries like Turkey and Argentina are in stark contrast to the generally stronger economic fundamentals across the broader emerging market complex, even relative to a few years ago. Asia remains a key focus of our emerging market exposures, particularly China, India, and South Korea, along with Brazil and South Africa, as well as others.

What do we like strategically about emerging markets?

A disciplined strategic asset allocation is responsible for around 80% of long-term investment performance—and diversification plays a critical role. Our research suggests emerging market equities should strategically represent 6% of a growth-focused portfolio (and 3% of a balanced portfolio). They are the fastest-growing part of the world; they provide access to secular investment themes; and they provide a good source of diversification.

The fastest-growing part of the world by far

In its 2018 World Economic Outlook, the International Monetary Fund forecasts growth in emerging markets to be at least two percentage points faster than in the developed world. Moreover, emerging markets economies, according to UBS Asset Management, “will contribute two-thirds of global growth over the next few years”, broadly split between China and the rest of the emerging markets. Over time, market capitalisation should follow growth.

Outside China, India remains one of the fastest-growing economies in the world, with UBS forecasting more than 7% growth in 2019 and 2020. Asia ex-China is also expected to grow by more than 5% in coming years.

Fidelity International highlights that, while emerging markets are 54% of global output, their equities were only 11.7% of the MSCI AC World index in 2010. Credit Suisse research notes that emerging Asia’s corporate bond markets are on course to represent nearly 30% of the global market by 2030.

Reflecting this, MSCI announced in March this year that it is quadrupling the weight of China’s mainland shares in its emerging market benchmark index. 

The weight of A-shares will increase from around 0.7% to 3.3% in three steps this year (May, August and November). According to MSCI, this could draw more than USD 80 billion of capital into China’s listed stocks (with some likely from other emerging markets). According to Reuters, “rival index publishers FTSE Russell and S&P Dow Jones indices will also both start adding yuan-denominated Chinese shares to their global benchmarks this year”.

Similarly, Chinese debt (the third largest bond market in the world according to JP Morgan) is increasingly being added to global bond benchmarks. In April 2019, renminbi-denominated government and policy bank securities will begin to be included in the Bloomberg Barclays Global Aggregate index. Emerging market debt can provide higher yields than developed markets—but this also comes with higher volatility. Still, Blackrock recently noted that investor perspectives on emerging market debt have been shifting from more tactical positioning to considering more structural portfolio positions.


Ability to access secular investment themes

Emerging market economies are transforming from commodity-intensive, domestic-infrastructure and export-manufacturing economies to services-based economies. Large pools of domestic savings are now able to fuel consumption as the primary driver of economic growth.

Emerging market consumer megatrend—In our latest Observation piece, Emerging market consumers—a megatrend shaping the world, our global equities specialist, Todd Hoare, notes that “the United Nations projects that the world’s population will increase by 41% to 8.9 billion by 2050, with nearly all this growth in developing countries.” Strong growth in working-age populations, urbanisation and a rising middle class are expected to underpin one of the most important megatrends of the next decade. While spending is expected to grow by 0.5-1.0% per year in developed economies, it is forecast to grow by a much faster 6-10% per year in developing economies.

Emerging markets enable investors to capture structural investment opportunities from the rapidly rising consumer demand to technology.

Beyond just ecommerce—When it comes to the emerging consumer, it is not uncommon for investors to default to just retail or ecommerce. Yet, there is a myriad of other opportunities ranging from education (where an estimated 100 million children have never been to school) to tourism (where less than 10% of China’s population holds a passport). Importantly, themes can also be intertwined. For example, rising emerging market food consumption cannot be separated from the scarcity of arable land, water needs, changing diets and health care. This provides a gateway to other themes—from investments in agricultural equipment, genetics, and seeds to water treatment, drug development, convenience eating and home delivery.

Rapid technology, research and development—Emerging economies, particularly China, continue to focus on rapid growth in technology.

According to the Financial Times, in 2016 China published more academic papers on artificial intelligence (AI) than all the countries in the European Union (EU), and it overtook the US in terms of the number of AI papers in the top 5% of ‘most cited research’.

Blackrock also highlights that in 2017, China outlined its goal to create by 2030 a world-leading USD 150 billion AI industry. Reflecting increased private sector involvement, in 2017 Alibaba announced it would spend USD 15 billion on AI, quantum computing and fintech over the next three years.

Diversification within an equity portfolio

According to Blackrock, "emerging markets have long attracted investors seeking stronger growth, higher income and alpha opportunities in less efficient markets.” In addition, over the past five years, the correlation of emerging market equities to their developed world peers has fallen from around 90% (similar to the correlation between US and European equity markets) to only about 70%. When we consider individual markets, such as India, their correlation to developed markets is around half of this figure.

Consequently, emerging market positions within a diversified equity portfolio can provide attractive diversification benefits. This is particularly advantageous as we negotiate the later stages of this macro cycle. Moreover, more recently, global economic shocks have been emanating predominantly from the developed economies (Brexit, trade wars, European politics) to emerging economies, rather than in the other direction.

Emerging markets have long attracted investors seeking stronger growth, higher income and alpha opportunities in less efficient markets.

Emerging market equities have a lower beta to developed equities

Source: Crestone, Bloomberg.


Is there a tactical argument for emerging markets?

We remain tactically overweight emerging market equities, suggesting an active portfolio weight between 5% and 8% for balanced and growth investors respectively. A number of the headwinds underpinning a 20% correction in 2018, including a strong US dollar and rising US interest rates, have tapered. But headwinds remain, including the recent China growth slowdown, China’s focus on improved credit quality and the ongoing geo-political flashpoints—Brexit and the US-China trade dispute. These could be viewed as potential upside catalysts, though a global recession or trade war escalation are also tactical risks.

Still, after their recent strong relative gains, emerging equity valuations are no longer as cheap as they were back in October 2018. 

But as UBS Asset Management argues, valuations are not expensive, while the broad health of emerging markets remains sound. Similarly, according to UBS, emerging market currencies are no longer oversold and best thought of as ‘fair’.

Emerging market equities are not expensive, but less cheap than in late 2018

Source: UBS, Crestone.

Are investors’ concerns warranted?

The higher long-term return opportunity in both emerging market equities and bonds necessarily embodies higher year-to-year volatility and risk than developed markets. However, given many emerging market economies are driven by local developments, this can be managed by an appropriately diversified exposure. According to Blackrock, weekly volatility in the emerging market MSCI index is around 2.5% compared with 1.9% for the S&P 500 index.

From a macro-economic perspective, foreign debt exposures and current account positions look materially better than they did two decades ago during the Asian Financial Crisis, and also look significantly improved from as recent as five years ago. Indeed, according to UBS Asset Management, on these metrics, only a few countries, such as Turkey, Argentina and Colombia, look problematic.

In regard to risks of government intervention in emerging market economies—while these risks remain, they appear no less significant than investors might experience in advanced economies, such as in the US (particularly in the technology and social media sectors), Australia (in terms of a broad range of sectors due to a potential change of government) or the UK (from Brexit).

Rule of law remains a persistent and warranted concern for emerging market investors. Uncertainty remains over how laws are enforced and where investors and corporates rank during disputes. Similarly, investing in emerging markets, particularly when not using an appropriate fund manager, requires attention to social responsibility—particularly environmental, social and governance issues, as well as issues of sustainability.

How to gain exposure to emerging markets

We prefer active management in emerging markets, where experienced managers can address the inefficiencies that can exist in less researched markets. This approach is best able to efficiently access growth opportunities across a broad spectrum of emerging markets, while addressing any potential governance issues more easily than a passive approach.

For those unprepared to venture into emerging markets directly, increased exposure to emerging market trends can be garnered indirectly via developed market corporates with significant emerging market exposure.

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