In our view, there is a strong strategic case for an allocation to emerging market assets; we do however recommend that investors follow an active, multi-asset allocation approach when they decide to invest.
In a nutshell, the argument for a strategic allocation is three-fold: First, developing countries tend to grow faster than developed ones (e.g. demographics, higher productivity growth, strengthening consumption). Secondly, there is a higher income potential, since emerging assets carry elevated risk premiums that tend to diminish over time as countries’ economies and policies improve. And thirdly, there is the diversification benefit arising when an allocation is made to emerging markets in a portfolio. Despite these positives, investors remain underweight in emerging market-related assets.
We expect this to change gradually as investors reflect on emerging markets’ already significant and growing share of global economic output (c. 40% of global GDP) and market capitalisation. This, in our view, will eventually shift the role of emerging market assets from that of a satellite to a core strategic holding.
When investors do decide to add strategic exposure we recommend they follow a dynamic multi-asset approach that allows for changes to regional and asset class exposure over time. Specifically, as we expect growth across emerging nations to become more heterogeneous once again, this will require a greater regional focus. Since emerging markets can be accessed through a number of asset classes each with different sensitivities to aspects of growth and various stages of the business cycle, there is greater scope for investment opportunities, diversification and thus better risk-adjusted returns in the long run.
Once again, growth turns more idiosyncratic
When looking across the first decade since the start of the millennium, emerging countries showed an unusually rapid and consistent economic expansion across all markets. This started with China’s growth accelerating in 1998 and growing its GDP for several years at 8% or faster. This positive impulse, helped by a goldilocks scenario of declining inflation globally, spilled over to global emerging markets, doubling their economic output from around 3% (simple average, annual GDP growth, 1980s-90s) to around 6% between 2003 and 2007 (see exhibit 1 below).
Exhibit 1: Emerging market economic growth (average growth of MSCI EM countries)
In the first decade of the 2000s, growth synchronised significantly, leading to the most homogenous patch of growth since 1950 (see exhibit 2). In fact, during this time, none of the MSCI EM countries experienced a contraction and 60% grew at 5% or faster (vs. 20% in 2000). Growth across emerging countries has since turned more idiosyncratic once again and should remain so, based on our thematic view for further divergence across emerging markets (e.g. differences in structural reform activity, policy outlook or sensitivity to the ending of debt and commodity cycles).
The ‘new normal’ in emerging markets will likely be more like the ‘old normal’ as seen during the 1950s to 1970s, when growth averaged around 5%, but divergence in activity was higher than seen today (with 5% vs. 3% in 2000s).
Exhibit 2: Dispersion in emerging market growth (interquartile range of MSCI EM countries)
With economic activity across emerging countries becoming less correlated, there is a need for greater regional discrimination, particularly when considering the concentrated regional exposure of the leading emerging market indices. For example the MSCI EM equity index is skewed towards more integrated economies with an allocation of around 70% to emerging Asia. Meanwhile the widely followed JP Morgan Emerging Markets Bond index (EMBI) favours Latin America, Eastern Europe and Africa (80% of the index, see exhibits 3 and 4). Due to these significant regional biases, an active approach to asset allocation can help avoid some of the pitfalls of merely tracking these markets passively.
Exhibit 3: Breakdown of the MSCI Emerging market equity index by region
Source: Datastream, BNPP IP, as at December 2015
Exhibit 4: Breakdown of the JP Morgan emerging market external sovereign debt index (EMBI index) by region
Source: Datastream, BNPP IP, as at December 2015
Broad access to emerging market themes
Aside from the regional perspective, emerging markets can be accessed through a number of different asset classes, including equities, sovereign and corporate debt as well as currencies or commodities. Such a multi-asset investment approach allows investors greater access to investment opportunities, as each of the assets reacts differently to aspects of emerging market growth.
By using a multi-asset approach investors can gain exposure to the actual themes underlying emerging market growth, whether it be greater macroeconomic strength (more debt/currency-related in view of inflation, fiscal and capital flow aspects) or aggregate demand outlook (more equity/corporate debt/currency-related based on productivity, company earnings/balance sheet aspects).
For example, looking at Brazil currently, the weak GDP growth backdrop combined with the government’s efforts to slash spending and the central bank tightening rates to lower stubbornly high inflation is a ‘red flag’ for equity investors. On the flip side, the positive underlying theme of Brazil’s improving fiscal policy and inflation outlook offer an investment opportunity in local currency debt.
Additionally, multi-asset investors can benefit from further diversification potential as assets offer different sensitivities to various stages of the business cycle. Considering this, and the greater potential for investment opportunities, a multi-asset approach can offer better risk-adjusted returns in the long run.
Handle with care
With a dynamic approach to allocating across asset classes or regions, investors can not only increase exposure to regions or assets that are attractive, but also reduce their exposure early in anticipation of deteriorating fundamentals or signs of elevated risk.
In comparison to developed markets, risks associated with investing in emerging markets can be more prevalent and require additional care and attention. These include risk of short-term ‘hot money’ capital outflows and lower liquidity during episodes of market stress, higher risk of sovereign restructurings/defaults and of ‘doing business’ (corruption, political and legal risks).
We see these factors as manageable via the monitoring of country-specific risk (e.g. cyclical outlook, credit risks or political developments) and currency developments. Emerging market currencies tend to exhibit higher levels of volatility particular when foreign investors dominate countries’ portfolio flows, which can become a de-stabilising factor when sentiment deteriorates. In both instances, risk can be actively controlled by reducing exposure when required.
Of course, the broad diversification provided by a multi-asset approach also helps to manage risks.
Having mainly focused on the ‘top-down’ asset allocation perspective, investors should not ignore the possible benefits of ‘bottom-up’ security selection. The returns from a multi-asset approach can be further enhanced by allocating investments in each asset class. BNP Paribas Investment Partners has strong emerging market expertise with the support of investment teams ‘on the ground’ in 14 emerging countries providing the necessary ‘local-flavour’ to its investment process.
BNP Paribas recently launched its first multi-asset strategy with a pure focus on emerging markets. Managed by the same team running the successful Global Multi-Asset Income strategy, the strategy targets an annual payout of between 5% to 7% by dynamically allocating across emerging markets asset classes and regions, whilst harnessing BNPP IP’s local presence in emerging markets.
 Divergence in growth measured as the difference between 1st and 3rd quartile GDP growth of the MSCI EM countries.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.