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February 2021 / VIDEO

Emerging Markets: Overlooked and Underrated?

Discussing the rationale for a strategic allocation to EM

In a Citywire roundtable event, investors examined why developing economies are yet to make their presence truly felt in globally diversified portfolios.

  • Yoram Lustig, head of multi-asset solutions for Europe, the Middle East, Africa and Latin America, T. Rowe Price
  • Roman Mayer, global head of fund advisory, UBP
  • Ulrich Voss, head of capital markets, Tresono Family Office
  • Bart van de Ven, advisor and fund selector, Accuro Wealth Advisors

Despite recent jitters, the fundamentals for emerging markets are strong. Even with global trade tensions and an uptick in volatility, the majority of panellists at Citywire’s virtual debate, in association with T. Rowe Price, argued the investment case for developing economies remained.

Traditionally, emerging markets (EM) have been a tactical play for many. But what is it about the structural story that excites investors?

Yoram Lustig, head of multi-asset solutions for Europe, the Middle East, Africa and Latin America at T. Rowe Price, identified three key reasons for a strategic allocation to emerging markets, with portfolio construction being one of them.

Emerging markets have a strategic role to play, especially if you manage portfolios on a global basis

- Yoram Lustig

‘At 10%, EM equity represents a meaningful weight in the MSCI All Country World index. China alone makes up around 5% of the index,’ Lustig said. ‘That just goes to show that emerging markets do have a strategic role to play, especially if you manage portfolios on a global basis.’

On the fixed income side, EM debt can offer investors superior growth and income while also adding to diversification. ‘They may be deemed a riskier asset class but allocating to emerging markets can actually reduce overall portfolio risk.’

But emerging markets have more to offer than diversification. Lustig also highlighted their return potential and referred to the widening gap between developed and emerging market equities: ‘Our five-year expected returns1 for US large-cap growth equities are currently 5.3% per year, compared to an annual 7.3% for emerging market equities. That’s two percentage points extra. In the case of EM debt, we expect returns of 3.9% for the next five years, compared to only 1.9% for global aggregate. Again, that’s an extra two points per year for emerging markets.’

On the whole, Lustig said, emerging markets potentially offer more opportunities to generate alpha than their developed peers.

Lustig’s third reason to strategically invest in emerging markets was what he called ‘the triple premium’, a trifecta of growth, demographics and change.

Emerging markets, as a group, are growing at a faster rate than their developed peers, boast a younger population and are currently going through a series of fundamental improvements, including a stronger focus on corporate governance, a rising middle class and more balanced economies. ‘Moderation in inflation, for instance, may lead to falling interest rates in some emerging markets, which could give an extra boost to asset prices,’ Lustig said.

Roman Mayer, global head fund advisory at UBP, agreed: ‘We see positive demographics and a lower debt burden, I think it’s fair to say that emerging markets have delivered.’

Emerging economies are considerably less dependent on commodity producers but are home to a rising number of stronger local businesses instead’

- Ulrich Voss

Emerging economies have experienced a remarkable growth trajectory over the past 20 years, with China leading the way. As Mayer pointed out, the biggest initial public offerings and technology firms in the world are coming from China. Yet many investors are still shying away from gaining exposure to emerging markets.

‘I understand that there are preoccupations against the volatility of EM equities, which tend to be higher than in other asset classes,’ he said. ‘I also get why you would want to have a home bias. But if you take a holistic approach to your portfolio, you should consider EM assets, whether fixed income, debt or frontier markets, as a strategic allocation without trying to time the market.’

Beware when the music stops

Mayer’s words resonate in the current environment of extremes. With an increasing number of investors concentrating their focus on fewer companies. ‘Everyone wants to own the Zoom’s, Google’s and Amazon’s, but this is not an infinite game,’ Mayer warned. ‘The party will stop at some point, so you better make sure that you have an appropriate diversification in place. However, there’s still this preoccupation which stops investors from allocating money to EM assets.’

Could a weak US dollar be a catalyst for investors to overcome reticence toward emerging markets?

Ulrich Voss, head of capital markets at Tresono Family Office, believes so, but he also urged investors to keep the bigger picture in mind: ‘You cannot see it in isolation. We have a weaker dollar, but we also have an environment where there are other problems due to the weakening demand in developed markets. In the long term, however, I think you need to have a strategic view on emerging markets.

‘There was an old saying in the 1980s or 1990s – “emerging markets are a market you cannot emerge from in an emergency”. But I think that’s changed. Emerging economies are considerably less dependent on commodity producers and are home to a rising number of stronger local businesses instead.’

Bart van de Ven, advisor and fund selector at Accuro Wealth Advisors, however, was not convinced to the extent of progress made.

Expressing his concern over the quality of EM assets, he said: ‘All the reasons to be in emerging markets – growth, demographics etc – were also there 20 years ago, but during that period, a lot of emerging markets like Brazil, Argentina, South Africa or Turkey had their problems, both in stocks and in bonds,’ he said. ‘We cannot find the quality we want in specifically these emerging countries, so we keep a very low allocation to emerging markets.’

T. Rowe Price’s Lustig, on the other hand, believes that the scarcity of high-quality stocks is a boon for active managers. ‘If you’re able to identify those pockets of quality, you can uncover hidden gems, whether that be companies or countries that are likely to benefit from future change,’ he said.

From his point of view, the general quality in emerging markets has improved significantly over the last two decades. Volatility has reduced considerably, while the drawdowns are no longer as severe as they once were. The portion of investment grade in emerging market debt indices has also increased, Lustig said.

‘Emerging markets have come a long way in terms of increasing quality, but you have to be able to identify this through fundamental analysis. It takes a lot of resources and hard work; it’s not easy, but that’s the advantage. I think the lack of widespread quality is actually an opportunity to add alpha. Yes, you have to be careful and selective, but that’s the beauty of the asset class.’

 

Key Risks

Transactions in securities denominated in foreign currencies are subject to fluctuations in exchange rates which may affect the value of an investment. Returns can be more volatile than other, more developed, markets due to changes in market, political and economic conditions. Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default which may affect the value of an investment.

 

 

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