Emerging Markets have long played a role In investment portfolios whether pension funds or retail investors. Investing in sometimes more “exotic” markets has been seen to be a way of tapping into higher returns while diversifying away risk.
Investors could have exposure to Coca-Cola bottlers in Argentina, software companies in India through to supermarkets in South Africa and all at (certainly in the early days) extremely attractive valuations. It became one of the most exciting themes in financial markets.
Emerging Markets (EM) as a term was recognised in 1981.
Investment fundamentals were based on super normal growth prospects due to features such as new wealthier middle classes across Latin America and Asia increasing the quantity and quality of their consumption at pace.
There were periods when EM provided turbo-charged returns to investors, and came to be seen as a separate asset class in itself.
Is the case for such investment still intact?
There are two aspects to this question – the near term impact of Covid and the longer trends that drive Emerging Market dynamics.
Pandemics increase whatever inequalities exist pre-crisis. Today poorer access to vaccines and weaker policy responsiveness are causing EM economies to slip back.
As recently as July, the IMF increased its growth forecasts for advanced economies while revising down the figures for the developing world. Excluding China, Emerging Market growth in 2022 will be significantly lower than for advanced economies. Rather than catching up with advanced economy growth rates, many emerging economies are slipping back and some run the risk of falling onto fragility.
This softer economic picture is compounded by policy responses such as interest rates. While developed market economies are still very much in the “lower for longer” phase, 50% of emerging market central banks have already raised interest rates.
Covid in EM will cast a long shadow in many forms.
Longer term productivity of human capital will be impacted by pandemic-driven loss of schooling time and again EMs have fared worst. In 2020 children in advanced economies missed about 15 days of school; in EM economies this figures was closer to 50.
So it’s clear Covid is a serious set-back for emerging economies. But in many ways it only exposed existing vulnerabilities.
The slipping relative economic growth picture for EM was already in place. Following the financial crisis, economic growth rates for developed economies fell by 50%, but for EM economies the drop was a more precipitous 70%. 2013 was the probably the last year when EM economies had an outstanding growth advantage.
When EM economies had their days in the sun, there were several more ingredients which supported the market explosion – interest rates were generally on a downward track, commodity price rises were supportive and trade globalisation moved up a gear.
Emerging economies exports surged as trade went from 39% of world GDP in 1990 to over 60% by 2008.
Throughout the period from 1980’s onwards, another very supportive force was a move to more liberal democracies especially in Latin and South America. The prospects for greater political stability, less corruption and higher and fairer incomes could only be positive for investors.
Against this backdrop and with attractive valuations, global pension funds and others rushed to capture this frontier market premium and drive markets up.
However today, many of these longer term trends are challenged.
Both near term and longer term, EM economic growth prospects are poorer. The share of countries where output per head is superior to the US continues to fall. Another feature is that from here interest rates cannot fall further and some policy makers are already in hiking mode. 2023 may see US rates themselves move up. Another positive pillar for EM in the past – globalisation – may have stalled and because of Covid may shift into reverse.
We’ve also seen a pause in the drive to more liberal and accountable regimes. The humanitarian disaster in Brazil, civil unrest in South Africa and roll back of fiscal reforms in Chile are all global signposts of this change of direction.
Investors need to take on board these longer term trends, as well as the short term impact of the global pandemic, when considering investing in Emerging Markets. This more challenging environment is visible in the market performance of EM. Over the last 10 years, global equities are up by 11% per annum; the figure for EM is 3.6%.
But as well as the “why” of investing, there is the question of the “how”.
Broad EM indices bring a number of issues. They can be highly concentrated. China for example accounts for 35% of the total index. This is up from 7% in 2003 . In the same period Mexico has gone from 8% to 2%. Concentration is also high at stock level. The top 3 stocks account for 16% of the index and the broad technology sector accounts for more than a third. This is not the widely diversified index that it may have been in the past. Events and policy decisions in China (such as the recent crackdown on educational tech companies) will have a profound impact on many EM benchmarks.
Are EM stocks cheaper? Yes – but the gap is nowhere as big as it was when interest in EM was very much in a growth phase.
There will always be room in investor portfolios for stocks and sectors that offer growth potential at reasonable valuations. For many years this was the EM investment case. Today the sector faces as many headwinds as tailwinds and needs to be an active decision not just a default response based on investment muscle memory.
Tradewinds 