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Emerging Markets

Emerging Markets: Reward or Risk?

Andrew Keirle, Portfolio Manager
Eric C. Moffett, Portfolio Manager, Asia Opportunities Equity Strategy
Scott Berg, Portfolio Manager, Global Growth Equity Strategy

Short‑term concerns, but potential for long-term gains.

Key Insights

  • Emerging markets (EMs) have evolved, and investors need to look at them through a different lens. It’s important to stay alert to the changes happening in this dynamic asset class. 
  • The multifaceted nature and higher dispersion compared with other asset classes offers more opportunity to create alpha. 
  • Trade disputes and slowing global growth are challenging, making the outlook more opaque in the short term. However, fundamentals remain strong and opportunities can be found.

Investing in the emerging world over the last 10 years has provided positive returns in both equities and debt, but far less than the same spectacular returns of the previous decade. Some are questioning if there are still rewards to be found within the developing world.

Strong evidence suggests there is, even though many investors remain structurally underweight the asset class, despite the importance of EMs to the world. Along with many secular drivers, EMs continue to demonstrate a range of growth characteristics that are not easily available in developed markets. This enables higher‑quality companies in certain sectors to generate sustainable earnings growth at a much higher rate than the global average. (Compounding returns can be a powerful driver of future returns.) Meanwhile, in the search for yield, EM debt offers much higher rates than developed markets, many of which now have negative yields. Valuations across the asset class also remain attractive, further supporting investment.

Do the Fundamentals Still Add Up?

Significant headwinds, such as the bursting of the commodity bubble, China’s slowdown, weak global exports, and the strong U.S. dollar, have clouded the environment over the last decade. We have also seen a narrowing of the economic growth premium versus developed markets, while corporate earnings growth has been weaker due to a combination of cost pressures (including wage growth) and softening demand. The increasing threat to globalization—only heightened by the trade dispute between China and the United States—is also one of the big challenges EMs now face as global supply chains become more disrupted.

Nevertheless, led by China, EMs are one of the most important drivers of global economic growth. Add to that, longer-term aspects like urbanization, productivity, and for many EM countries, far more attractive demographics, and you get an opportunity set with many interesting and attractive investments.

Past Performance Is Not a Reliable Indicator of Future Performance

In the late 1990s and early 2000s, EMs delivered outsized returns relative to developed markets. Many EM economies were boosted by China’s double‑digit growth pace and massive investment in resources, leading to what was termed the “commodity supercycle.” This resulted in a virtuous cycle that benefited EM countries broadly—and several large countries in particular, such as Brazil, South Africa, and Russia, where natural resources are plentiful. It also meant that performance was heavily influenced by the direction of commodity prices.

However, as China began its transition to a more consumer‑led economy, that powerful tailwind of rising commodity prices dissipated. This has been especially apparent over the last five years as the relationship between commodity prices and EM equities weakened significantly. As seen in Fig. 1, EM equities moved almost in lockstep with energy prices from 2005 to mid‑2014, but have since moved with less correlation as the weight of those commodity sectors declined in the index. By contrast, information technology, internet and consumption sectors increased (Fig. 2) and have become more influential.

What we have to recognize is that EMs are a different animal to what they were 10 years, or even five years ago. The term “emerging markets” is now more a matter of benchmark classification as opposed to some common fundamental factor. While perhaps sounding like a subtle distinction, it is an important one.

(Fig. 1) EM Equity Performance No Longer Riding the Commodity Cycle
EM equities less correlated with energy prices
Cumulative performance, January 2005 to August 2019

Past performance is not a reliable indicator of future performance.
Sources: FactSet (see Additional Disclosures), and MSCI (see Additional Disclosures).

(Fig. 2) The New Driving Force Within Emerging Markets
Consumer and technology sectors rise in importance to the detriment of commodity-related areas
MSCI Emerging Market Index Weightings

Sources: FactSet (see Additional Disclosures), and MSCI (see Additional Disclosures).

Evolution and Durable Change, With China at the Heart

Economists have long predicted that rising EM incomes would propel a shift from export‑led to consumption‑led growth, and this shift is well underway in many emerging markets. China is at the heart of this, with its industrialization phase clearly and intentionally fading, while consumption and services sectors have become far more important.

Other EM economies are similarly having to adapt to this lower‑growth world. Many are becoming more self‑reliant and increasing trade among themselves, reducing their dependence on developed markets, and the U.S. in particular. This is a marked shift and should further spur their own development.

Rising Dispersion

With this ongoing trend toward more domestically driven economies, EM fundamentals are becoming more localized, making broad generalizations about the asset class even more tenuous. One only needs to look at performance on a country‑by‑country basis to see that they cannot be viewed under one homogenous banner anymore.

This dispersion also means that we need to adjust our assumptions about what environments could be most beneficial. Falling oil prices may be a catalyst for poor performance within Russia or the Middle East, but it may mean that consumers in China and India have more disposable income to spend on food, travel, or entertainment—areas that are now more heavily represented within EMs.

This ongoing change represents both a challenge and an opportunity. The playbook for allocating to EM equities and bonds is no longer solely cyclically driven. In the past, we used to ask questions like: Do you think global growth will be healthy? Do you think commodity prices will be strong? Do you think EM currencies will be stable? If the answer to all these questions was yes, then EMs were very likely to outperform other regions. Now one must concede that it is much more complicated. Macro factors like global growth, commodity prices, and currency markets are still important, but they are now part of a much broader mosaic.

The opportunity lies in the recognition of two important realities: (1) EMs may continue to offer stronger economic growth trajectories than developed markets and (2) EMs now reflect a wider range of country‑, sector‑, and stock‑specific influences. Point one argues for the need to have exposure to EMs in portfolios with long time horizons, while point two argues for the need to gain exposure in a more active way to identify the best opportunities within EMs now.

(Fig. 3) Looking for Yield?—Turn to EM Debt Markets
EM Debt offers investors much higher rates of yield than other areas.
As of July 31, 2019

Past performance is not a reliable indicator of future performance.
Sources: Bloomberg Index Services Limited (see Additional Disclosures), J.P. Morgan (see Additional Disclosures). Returns are in U.S. dollar terms. Data analysis by T. Rowe Price.
Benchmarks: EM Sovereign Hard Currency: J.P. Morgan EMBI Global; EM Sovereign Local Currency: J.P. Morgan GBI – EM Global Diversified; EM Corporate: J.P. Morgan CEMBI Broad Diversified; Euro High Yield: Bloomberg Barclays European High Yield; US High Yield: Bloomberg Barclays U.S. High Yield; US Investment Grade: Bloomberg Barclays U.S. Corporate Investment Grade; Euro Investment Grade: Bloomberg Barclays European Corporate Investment Grade; U.S. Treasuries: Bloomberg Barclays U.S. Aggregate – U.S. Treasury; International Bonds: Bloomberg Barclays Global Aggregate ex U.S.; Bunds: Bloomberg Barclays Global Aggregate – German Bund; JGB: Bloomberg Barclays Global Aggregate – Japanese Government Bond.

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Emerging Markets: Reward or Risk?

Additional Disclosures
Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2019, J.P. Morgan Chase & Co. All rights reserved.

Financial data and analytics provider FactSet. Copyright 2019 FactSet. All Rights Reserved.

MSCI and its affiliates and third party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

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