Emerging Markets

Questions Investors Should Consider for an Optimal EM Allocation

A Q&A with our multi-asset solutions team.

Justin Harvey, CFA, ASA, Solutions Strategist for Multi-Asset Solutions
Yoram Lustig, CFA, Head of Multi-Asset Solutions, EMEA
Lowell Yura, CFA, ASA, Head of Multi-Asset Solutions, North America

Key Insights

  • We believe that the most successful long‑term investors will recognize that each emerging markets (EM) asset class should play a defined role in their portfolio. 
  • The EM opportunity set is diverse and growing and offers different opportunities depending on investors’ objectives and time horizons. 
  • Historical returns, volatility levels, and correlations can help investors decide which asset classes are best suited to their goals and risk tolerance levels.

There are many arguments in favor of investing in emerging markets (EM). The diverse opportunity set offers attractive yields, and many areas remain undervalued. However, it’s crucial to understand that not all asset classes within the EM universe are the same. Different areas and asset classes within EM offer different potential benefits, risks, and characteristics. Below is a series of questions that investors should address to help guide their EM investments.

(Fig. 1) EM Equity and Debt Offer Attractive Track Records
Equity and hard currency debt returns in developed markets (DM) and EM
As of September 30, 2019

Past performance is not a reliable indicator of future performance.
EM Equity: MSCI Emerging Markets Equity Index; DM Equity: MSCI World Index; EM Debt: J.P. Morgan EMBI Global Diversified Index; DM Debt: Bloomberg Barclays Global Aggregate Bond Index.
Sources: MSCI (See Additional Disclosures), J.P. Morgan (See Additional Disclosures), and Bloomberg Index Services Limited (See Additional Disclosures).

What Role Should EM Play in an Investor’s Portfolio (e.g., Income, Growth, Diversification)?

We believe the most successful investors will calibrate their expectations for each asset class based on the defined role it plays in their portfolios. Therefore, when deciding where to invest in the EM opportunity set, investors should consider what goal they are trying to achieve and which asset classes are best suited to reaching that goal.

Some investors may want to maximize their long‑term returns, others will prioritize stable income generation, and some may primarily invest in EM to add diversity to their portfolios. Looking at the track records, behaviors, and different characteristics of the main EM asset classes can help investors determine what each asset class can do to help achieve their goals.
 

  • Growth‑seeking investors can find opportunities to help achieve their goals in all segments of the EM universe. Both equity and fixed income markets possess strong growth potential, highlighted by EM hard currency debt and EM equity’s outperformance against their developed market (DM) counterparts over the past 15 years. Investment in EM, overall, has grown significantly in the past 15 years as many EM economies matured. As a result, sovereign spreads have come down and were one factor behind the climb of equity prices.
  • Many segments of EM offer strong income potential relative to their developed market counterparts. In a world of low, or even negative, developed market bond yields, the higher yields in EM debt offer investors opportunities to locate attractive income, some at investment‑grade creditworthiness. Hard currency sovereign and corporate bonds reduce the risk that returns will be impacted by swings in EM currency markets. 
  • For diversification needs, investors should remember that as risk assets, both EM equity and EM debt will not necessarily provide diversification with respect to global equity markets. However, an active approach seeks to uncover specific EM opportunities in countries or companies undertaking positive reforms that could potentially generate alpha in different market environments, and this alpha may be lowly correlated with general equity market movements. EM local currency bonds could allow investors to invest in countries at different points of the monetary cycle than their home country. This opens up opportunities to diversify away from U.S. Treasuries, German bunds, or other core developed government bond markets.

(Fig. 2) Positive Returns Across EM
Performances by EM asset class over past 15 years
As of September 30, 2019

Past performance is not a reliable indicator of future performance.
EM Equity: MSCI Emerging Markets Equity Index; EM Frontier Market Equity: MSCI Frontier Emerging Market Index; EM Debt: J.P. Morgan EMBI Global Diversified Index; EM Corporate Debt: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified; EM Local Currency Debt: J.P. Morgan Government Bond Index‑Emerging Markets.
Sources: MSCI (See Additional Disclosures) and J.P. Morgan (See Additional Disclosures).

(Fig. 3) EM Volatility Has Declined
Rolling volatility by EM asset class
As of September 30, 2019

Past performance is not a reliable indicator of future performance.
Volatility is measured by standard deviation and is calculated over rolling 3-year periods.
EM Equity: MSCI Emerging Markets Equity Index; EM Frontier Market Equity: MSCI Frontier Emerging Market Index; EM Debt: J.P. Morgan EMBI Global Diversified Index; EM Corporate Debt: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified; EM Local Currency Debt: J.P. Morgan Government Bond Index‑Emerging Markets.
Sources: MSCI (See Additional Disclosures) and J.P. Morgan (See Additional Disclosures). Data analysis by T. Rowe Price.

What Is Your Time Horizon?

The time horizon of investors can impact which asset classes within EM are best suited to their goals. Investors should consider differences in historical returns and volatility levels to help determine an optimal allocation for their planned investment period.
 

  • 3–5 Years—Although, overall, EM risk levels have come down in recent years, drawdowns can disrupt returns without sufficient time for losses to be recouped as markets recover. Therefore, time horizons under three years may be too risky for significant allocation to EM. However, investors can reduce the risks in the three‑ to five-year bracket by focusing on asset classes with lower historical volatility. The relatively low historical drawdowns in the EM sovereign and corporate debt asset classes make these attractive options for investors with shorter time horizons. Hard currency EM debt also allows investors to sidestep the swings in foreign exchange markets. 
  • 5–10 Years—A medium‑term investment horizon allows for more recovery time, adding to the options for investors who want exposure to asset classes that might be more prone to short‑term price swings but can deliver strong performance over the full market cycle. For example, EM local currency bonds along with the EM hard currency and corporate debt could play an important diversifying role. EM equity’s potential for outperforming its developed market counterpart also makes it a viable option, particularly for time horizons approaching 10 years.
  • With a longer‑term horizon—The full breadth of EM asset classes comes into view due to the ample time for recovery periods should drawdowns weigh on returns. Investors can seek to add stability by maintaining exposure to EM hard currency sovereign and corporate bond assets as well as diversity through EM local currency debt allocations. Additionally, high yield EM asset or frontier markets offer an expanded investment opportunity set and idiosyncratic investment opportunities from a bottom‑up perspective. While these sectors may hold the most risk, the longer time horizon allows for recovery and potential outperformance as specific countries or companies reform and grow.
Opening Quote Growth‑seeking investors can find opportunities to help achieve their goals in all segments of the EM universe. Closing Quote
— Lowell H. Yura

(Fig. 4) Differences in Performance and Recovery
Drawdowns by asset class over time
As of September 30, 2019

Past performance is not a reliable indicator of future performance.
EM Equity: MSCI Emerging Markets Equity Index; EM Frontier Market Equity: MSCI Frontier Emerging Market Index; EM Debt: J.P. Morgan EMBI Global Diversified Index; EM Corporate Debt: J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified; EM Local Currency Debt: J.P. Morgan Government Bond Index‑Emerging Markets.
Sources: MSCI (See Additional Disclosures) and J.P. Morgan (See Additional Disclosures). Data analysis by T. Rowe Price.

What Correlations Should Be Considered?

EM investments are also risk assets, meaning that both EM equity and fixed income will typically show positive correlation to global equity markets as well as global high yield bond markets. While it is true that EM is more diverse and less risky than it was 10 or 20 years ago, investors should be prepared for drawdowns and volatility during periods of wider risk aversion that might also impact global equities. Investors should consider this correlation when deciding how their EM allocation fits into their overall portfolio.

Investors should also think about how EM debt and equity markets are correlated to core bond rates. Some elements of EM, such as EM equity, may show a negative correlation. Generally speaking, a rally in core DM bonds may suggest global investors are more risk averse and are moving away from EM risk assets to the perceived safety of DM government assets. Conversely, a positive global backdrop may see investors shift to riskier and higher‑yielding EM assets, which would boost EM asset prices while core DM bonds sell off. Investors seeking diversification should consider these interactions when designing their portfolios. Additionally, local currency EM bonds could offer diversification opportunities as returns in individual markets are driven by interest rates, inflation, and fiscal and central bank policies in their respective countries.


Additional Disclosures

© 2019 CREDIT SUISSE GROUP AG and/or its affiliates. All rights reserved.

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.

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

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.

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.


Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc.

© 2019 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

201910‑977879

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