Re-Emerging Markets: Investing In A Developing Recovery by Morgan Harting, Shamaila Khan, Laurent Saltiel, Sammy Suzuki

There’s a new buzz sweeping through emerging markets. Fundamentals are improving and valuations look attractive. Returns and flows are showing signs of life. For investors who have been underweight, developing-world assets now look very tempting.

From Peru to the Philippines, today investors can find an array of countries, companies and currencies that offer promising return potential. But before jumping back in, it’s important to consider what has changed after several tough years.

In the past, investors could succeed by riding the so-called “beta trade,” as emerging-market equities and fixed income delivered powerful returns over time. But today, without a rising tide to lift all boats anymore, investors can no longer rely on a broad market recovery to drive returns. As a result, we think it’s essential to stay active in emerging markets and take a highly selective approach to create portfolios that can deliver long-term outperformance. It’s also important to move away from emerging-market (EM) benchmarks, which are backward-looking and don’t reflect the most promising future investment opportunities.

Improving Fundamentals

Stocks and bonds have both recovered sharply in 2016. During the first eight months of the year, the MSCI Emerging Markets Index advanced by 14.8%, outpacing developed equities. In fixed income, the J.P. Morgan Emerging Market Bond Index rose by 14.6% over the same period. Following the large net outflows in 2015, investors have been adding money to EM funds again in 2016. Asset-allocation funds have started to gradually increase their exposure to emerging markets—and for good reasons:

  • Growth: Overall GDP growth across emerging markets has slowed from the breakneck pace of several years ago, but appears to have stabilized. Commodity prices have started to rebound from a slump, helping support more commodity-dependent countries. Corporate earnings are forecast to grow by 6% in 2016 (Display, left), according to consensus estimates, versus flat or negative growth in many developed-world countries. Earnings growth is already playing a big role in this year’s equity rebound (Display, right)
  • Inflation: Inflation remains well contained in most emerging economies, and the recent stabilization of exchange rates could provide room for additional stimulus
  • External Accounts: Current account positions are improving from the lows seen in 2013
  • Politics: Political risks can’t be overlooked, but there are encouraging changes taking place in various countries, such as Brazil, Argentina and India, that should further boost investor sentiment

Emerging Markets

Emerging Markets

Supportive Technicals

Investors are paying attention to these improvements. Following the outflows in 2015, new capital has started to flow back to both stock and bond funds that focus on the developing world. Still, most global investors remain underweight: global equity funds have a much lower allocation to emerging equities than they’ve had over the past decade (Display).

Emerging Markets

Attractive Valuations

Attractive valuations are providing another catalyst to boost exposure. EM stocks are trading at a 24% discount to global developed stocks based on price/earnings value (Display, left). Credit spreads for high-yield debt in emerging markets are now 0.9% higher than spreads for US high yield, and the spread on investment-grade EM debt is now 0.4% more than it is for US BBB corporates (Display, right).

Emerging Markets

For investors seeking to capitalize on the long-term growth and dynamism of emerging markets, we believe that equities offer the best return potential. At the same time, EM debt also offers solid excess return potential, and can play an important role in investor allocations given the challenges facing developed-market sovereign debt and investment-grade credit.

In equities, investors can choose from a spectrum of strategies. Lower-volatility strategies can help investors generate long-term outperformance by mitigating the downside in falling markets, enabling them to stay invested over the long term through turbulent episodes. Strategies that focus on high-growth companies can provide powerful earnings-compounding benefits by positioning to profit from tomorrow’s growth drivers—while avoiding stocks and countries that were beneficiaries of yesterday’s growth. And a multi-asset approach can make active trade-offs between stocks, bonds and currencies, generating attractive risk-adjusted returns over time by tapping into the widest opportunity set.

Beyond Benchmarks

No matter which approach an investor chooses, we believe that it’s important to focus on high-conviction managers who aren’t constrained by a benchmark. For bond investors, the best results come when a portfolio’s horizons are expanded beyond traditional benchmark limits to allow global multi-sector investing across the rating spectrum and across currencies.

In equities, the MSCI Emerging Markets Index is dominated by countries that are growing slower than average. South Korea and Taiwan—two fairly mature economies—together account for more than a quarter of the total benchmark. Benchmarks of countries including China, Brazil and Russia are heavily skewed toward state-owned companies, which often suffer from poor corporate governance and heavy government intervention. We believe that moving away from the benchmark can help investors identify the most promising holdings among thousands of diverse investment candidates, from a Colombian bank to a South African media group to a Chinese education company.

Emerging markets are presenting exciting opportunities for investors today. Investing success requires asset managers to develop unique macroeconomic, industry and country insights based on an understanding of how developing economies and countries fit into an increasingly integrated global economy. With these guiding principles in mind, we believe that investors can gain the confidence to increase their exposure to emerging markets—and maximize the potential benefits of a developing recovery.

This blog was originally published on InstitutionalInvestor.com

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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