Fast-growing emerging market economies have been an important source of returns for many investors over the last decade. However in the last year, returns from emerging markets have been more volatile. In order to gain the best risk-adjusted returns in future, investors need new strategies.
While economic data supports a positive outlook for developed markets, data also shows emerging economies are slowing. This has led investors to withdraw, which has in turn exacerbated the volatility and decline in value of both assets and currencies in these economies.
This volatility can’t be blamed solely on the US Federal Reserve’s plans to taper stimulus, nor can it be blamed solely on the rebalancing of China’s economy away from infrastructure and exports and towards domestic consumption. Another significant factor may be an internal one, that is, structural weaknesses in countries where reforms are long overdue.
It is becoming increasingly clear that the strong economic growth of many emerging market economies, and their reliance on the Chinese growth story, has concealed structural problems.
It has helped mask serious governance failings, corrupt practices and disregard for environmental regulation. Painful adjustments that should have been undertaken years ago have been delayed.
Emerging markets have relied on low interest rates overseas and plentiful liquidity, while productivity and efficiency have deteriorated. Foreign fund flows have fueled consumption but not investment (except in China), leaving many vital sectors under-invested. Perhaps the most important dynamic now affecting these economies is the high expectations of a politically active middle class. Recent protests in Brazil, Turkey and Russia show that policies more acceptable to a majority will require major structural reforms.
Despite this, investment opportunities can still be found and emerging markets should have a meaningful allocation in investors’ diversified portfolios. As large, young populations become wealthier, they offer investors undeniable opportunities, and companies in developed countries will see these regions as engines of future profit growth. While the larger emerging economies are experiencing difficult adjustments, growth may come from smaller frontier markets, such as Nigeria and Colombia.
Economies that embark on structural reforms will, in the short term, be out of favour and likely be at risk of weaker profits while countries that continue with fiscal and credit stimulus may experience higher short-term growth and profits.
A more selective investment approach is needed.
Given the individual complexities of each emerging market economy, and the unique headwinds they face, investors need strategies to both access their growth and manage a wide range of risks. Strategies that simply follow traditional emerging market benchmarks, investing in either shares or bonds, may expose investors to too much risk.
For example, a pure share or bond manager with a fund that’s benchmarked against an index and has liquidity requirements will be forced to have exposure to certain countries and sectors without regard to their valuations. These strategies may struggle if emerging economies slow further.
A more efficient portfolio exposure is through a strategy that gives an investment manager flexibility to invest across many types of assets. Such a strategy might include both shares and corporate bonds of any emerging country, and government and semi-government bonds in both local currency and US dollars. This approach provides good diversified exposure and allows a manager to carefully select mis-priced assets, while not holding expensive and overheated parts of the market.
The manager will have still more flexibility and access to emerging market consumers if they can invest not just in companies listed in those markets, but also in global firms that are listed in developed markets and derive substantial earnings from emerging countries.
To access the opportunities and manage the risks of emerging markets, investors should focus on prudent exposure through a strategy which recognises these countries’ differences and can flexibly alter its investments as the market changes.
Kajanga Kulatunga is a portfolio specialist at MLC Investment Management.