It has been a torrid year on financial markets. Stagnant economic growth and soaring inflation have sent global stocks and bonds falling in tandem, leaving investors “nowhere to hide” according to the head of AllianceBernstein, the giant US asset manager.
So this may not seem an ideal time to take a bet on emerging markets, traditionally a very volatile asset class — particularly not for retail investors, who mostly lack the time and the knowhow to gather information on the vast and varied world of developing economies.
Yet this is what some asset managers suggest. Pictet, the Swiss bank, for example, says emerging market equities could deliver double-digit annual returns over the next five years. It recommends them not as a speculative punt but as part of a balanced portfolio.
FT Money takes a look at the arguments of the bulls and the bears at this difficult time in financial markets — and considers what might be right for retail savers.
Emerging markets as an asset class have been around since the late 1980s, often delivering returns that investors in comparatively staid markets in the rich world could only dream of. In the six and a half years from when China joined the World Trade Organization in late 2001 — turbocharging emerging economies with its apparently insatiable demand for the raw materials many of them produce — to the eve of the global financial crisis of 2008, emerging market equities delivered returns of 300 per cent in US dollar terms. American stocks managed a fifth as much in the same period.
Since then, however, US stocks have staged a steady march upwards while EM stocks have gyrated.
This year, investors have taken flight. Mutual funds and exchange traded funds, the main vehicles for retail investors and for many institutional investors, have dumped an estimated $40bn of emerging market bonds this year according to EPFR Global, a Boston-based research company that tracks fund flows. Flows into EM equity funds, which held up well last year on the promise of a post-pandemic recovery, have also turned negative this year.
The benchmark stock index, the MSCI-EM, fell by almost a third in dollar terms between early January and mid May, before staging a partial recovery.
Investors have plenty of reasons to worry. This year’s surge in inflation worldwide, rising interest rates and a widespread slowdown in economic growth are all bad for EM assets, as investors worry that these often vulnerable economies will be hurt the hardest. China’s aggressive zero-Covid policy, with its paralysing lockdowns, and Russia’s war in Ukraine make the outlook bleaker.
The question is, how long will the bear market last? The forces arrayed against emerging markets are powerful and show little sign of fading any time soon. Nevertheless, a handful of asset managers are saying now could be the time to get involved. While the outlook for the rest of this year remains deeply uncertain, they say, this could still be a good entry point for those with a five to 10-year horizon.
“Valuations today are attractive,” says Arun Sai, senior multi-asset strategist at Pictet Asset Management in London. “We are not saying they are going to shoot the lights out, and investing in EMs tactically is never a valuation call. But where valuations do help is in guiding returns over the medium to long term.”
Dzmitry Lipski, head of funds research at Interactive Investor, a UK online investment platform, also sees valuations as attractive, especially for EM stocks, which are trading at a discount to those in developed markets.
“Nevertheless, investors should be very cautious and selective, as the asset class consists of a diverse collection of countries and companies,” he says.
Forces lined up against EM
Valuations are low for several reasons, of course. Chief among them, says David Hauner, head of EM strategy and economics at Bank of America Global Research, is tightening global financial conditions, as the US Federal Reserve, the world’s biggest central bank, begins raising interest rates and reversing the flood of stimulus it has poured into markets during the pandemic.
“The prospects for EM assets can mostly be summarised by the level of global liquidity, which in this case is clearly getting worse,” Hauner says.
The amount of liquidity, or money looking for investments, in global financial markets is a core driver of asset performance. Since the global financial crisis of 2008-09, central banks in advanced economies, led by the Fed in the US, have run aggressive bond-buying programmes to encourage investors to buy risky assets, hoping this will boost economic activity and output.
It is debatable whether such purchases, known as quantitative easing or QE, did much to drive economic growth. But they have certainly done a lot to boost asset prices. Now, however, those policies are going into reverse. This year, the Fed has begun to raise interest rate and to swap quantitative easing for quantitative tightening, or QT.
Although QT only got under way officially at the start of June, CrossBorder Capital, a London-based analytics firm that monitors global liquidity, says the Fed has been discreetly withdrawing liquidity from US money markets since December. In a report this month, it says such withdrawals already amounted to a net $1tn, more than a tenth of its balance.
Drawing a direct correlation between global liquidity and global wealth, CrossBorder Capital says: “A rising tide may well float many boats but a tsunami of monetary tightening unquestionably sinks asset markets. More pain lies ahead.”
For emerging market assets, rising interest rates and falling liquidity can be especially bad news. When times are good, EM stocks and bonds attract interest from so-called crossover investors — people who do not typically invest in EMs but will put some of their money in when times are good. They tend to be slow to join but quick to leave when the tide turns.
Incentives for such investors have changed dramatically over the past year. A year ago, the 10-year US Treasury bond — the benchmark “risk free” asset — paid a yield of about 0.75 per cent. Today, it pays more than 3 per cent — more than a Chinese 10-year government bond.
For EM bond investors overall, the outlook this year is bleak. In any economy, rising interest rates cause bond prices to fall, as investors expect higher rates to slow economic growth. As inflation and rising rates in advanced economies push up the yields on so-called safe assets such as US Treasury bonds, they also stoke anxiety about economic growth worldwide. This in turn raises fears of insolvency among bond issuers in developing economies, so that their bonds fall in price by more than those in the rich world.
A related headwind to rising interest rates is the rising US dollar. The Fed’s index of the dollar’s value against a basket of 26 global currencies, which fell for almost a year from its most recent peak at the start of the pandemic, has bounced back and reached a new record high last month. This is a worry for emerging market governments and corporates that borrowed in foreign currencies, as well as those that borrowed at variable rates. As the World Bank has noted, external public debt in developing countries is at record levels. It warns: “Debt distress — previously confined to low-income countries — is spreading to middle-income countries.”
Many larger EMs, including Brazil, India and South Africa, have avoided foreign exchange risk by borrowing in their own currencies. But they have also had to raise interest rates early and aggressively to fight inflation. Even for them, rising borrowing costs are a drain on other fiscal resources, putting a brake on investment for growth.
Since the one-off boost to commodity exporting EMs from China’s arrival at the WTO, many developing economies have struggled to find a new path to growth.
For investors able to do the research, investing in EMs has become increasingly an issue of diversification, with many questioning the validity of lumping so many different countries together in a single asset class. When the MSCI EM index — the benchmark for many equity funds — was launched in 1988, Malaysia was the biggest EM, with more than a third of the index; China only joined in 1996, with a weight of just 0.46 per cent.
Today, Chinese equities make up more than 30 per cent of the MSCI EM, followed by Taiwan, India, South Korea and Brazil. Russia has been dropped altogether after its invasion of Ukraine.
Raw materials, which used to dominate, now account for just 9 per cent, with less than 8 per cent split between energy and utilities. Financials, information technology, consumer discretionary and communications services make up two-thirds of the index.
Today’s composition, EM enthusiasts argue, leaves these economies well positioned to gain from post-pandemic, postwar, post-stagflation world development, when (and if) it comes.
Calling the bottom
Brett Diment, head of emerging market debt at Abrdn, a London-based asset manager that specialises in emerging markets, argues that recent rises in US interest rates have already started to tilt the balance by slowing the US economy and reducing the appeal of the dollar.
Another factor that could soon start to weigh in favour of emerging market assets is the relative pace of US economic growth compared with the rest of the world. While other advanced economies are unlikely to catch up with US growth rates soon, a narrowing in the gap may be enough to encourage US investors to think again about overseas assets. That could also be good for emerging market assets.
The problem is that most emerging markets are struggling to deliver very much economic growth at all. The World Bank, in a report this month, warned that per capita output growth in developing economies outside China will be slower this year and next than in advanced economies.
This undermines the basic case for investing in EMs at all — that they grow faster than advanced economies.
“What debt investors in particular are looking for [in emerging markets] is improvements in balance sheets, better fiscal situations, better current accounts and so on,” says Hauner at Bank of America. “But net-net, EM is likely to deteriorate and when you go down into the countries, it is very hard to find stories where this or that country is on an improving path.”
This is especially true of China — for many years the biggest single engine of EM growth — where investors worry the government will struggle to exit from its aggressive zero-Covid policy. This has shut down large sectors of the economy, dragging down growth rates both for China and those developing countries that rely on it as an export market.
Nevertheless, there may be grounds for optimism. This year, for sure, Covid-19 casts a shadow over Chinese growth. So does geopolitics with Russia’s invasion of Ukraine and increased fears that China will attempt to take Taiwan.
But Sai at Pictet argues it is a given that the pandemic will pass and sees encouraging signs in a moderation of the amount of new regulation the Chinese government has imposed on various areas of economic activity.
“Our view is that [the recent increase in regulation] is the government putting in guardrails for Chinese corporates to operate in,” he says. “Have we been able to time this? No. Have people called for a let-up in the past, which has not materialised? Yes, and we have had false starts.
“But this is not the Chinese leadership rewriting its economic model . . . we think this headwind will fall away, and that should lead to some reasonable re-rating.”
Until recently, expectations for Chinese equities were often unrealistic. He says: “That has been washed out now, so some of that froth has been skimmed off.”
Still hanging over the investment outlook, however, is Russia’s war in Ukraine. António Guterres, the United Nations secretary-general, warned this month that the war was “threatening to unleash an unprecedented wave of hunger and destitution”.
The damage will be particularly severe in developing countries, with the worst impact for those countries most affected by the disruption in supplies of food and fuel from Russia and Ukraine.
Conversely, for alternative suppliers, such as the commodity exporters of Latin America, there have seen some gains — although these may be overshadowed by a bigger overall hit to EM growth as a result of the war.
Time to dial up the risk?
While mindful of these risks, some analysts say a good part of the potential downside is already reflected in EM asset prices. Diment at Abrdn says: “We are looking to get a little bit less defensive across our EM strategies, adding a bit of risk.”
Pictet’s latest five-year outlook report, published this month, predicts that returns over that period will be driven by commodities, private markets and EM.
For the sake of simplicity, Sai says, Pictet takes as its benchmark a 50/50 split between global stocks and bonds, with 5.5 per cent allocated to EM equities. With today’s outlook, this would deliver only about 2 or 2.5 per cent annual returns over five years.
But double-digit returns are possible from EM equities and other high-risk assets, including alternatives such as infrastructure, real estate and private equity, he says.
To achieve 5 per cent returns with a reasonable level of risk, he says, investors should first adopt a more conventional allocation split of 60/40 in favour of equities, with 14 per cent in EM equities. For those with greater appetite for risk, Pictet suggests putting almost a quarter of a portfolio into alternatives, leaving a bit less than 30 per cent in bonds and about 50 per cent in equities, with 13 per cent in EM stocks.
Lipski at Interactive Investor notes that investor behaviour on the platform this year has mirrored that of global markets, with sharp outflows from all three of the main investment vehicles — funds, investment trusts and exchange traded products.
Savers who now go back into the markets, including EMs, need to take care. Lipski cautions that it is not a good time to rely on passive funds that mirror the benchmark indices, which were so popular in the bull market.
He says: “As there are likely to be clear winners and losers in this market, active managers employing more flexible approach and accurately managing risk, should be a better choice for investors.”
In other words, investors who decide that the sell-off is a time to buy, should do their homework. Those who want to spend less time managing their investments might be more comfortable in less tricky waters.