Emerging markets: A strategic component in your portfolio
"We continue to hold an overweight position in corporate emerging market credit, and emerging market currencies remain a preferred theme. Within equities, we are neutral on emerging markets."
Many investment managers focus on developed regions at the expense of those with greater potential for growth. The main reason for this is that emerging markets (EM) have historically been associated with instability and uncertainty regarding economic and political developments. Investors based in developed economies also tend to underweight EM due to a general human tendency to invest in what is familiar.
This instinct to favor the familiar over the unknown, however, can lead to investors missing out on growth opportunities elsewhere, and to overvalue domestic assets over international ones. This is especially so in an environment where fundamentals of emerging economies today have improved vis-à-vis developed economies, with lower levels of debt, moderate inflation and better fiscal accounts. Against the backdrop of low interest rates, abundant liquidity from major central banks, and superior growth prospects in EM economies, we believe EM currencies, equities, and corporate bonds remain relatively attractive asset classes. These assets are also underrepresented in most clients’ portfolios.
Currencies an underappreciated asset class
In recent times, we have witnessed a great deal of activity among the central banks of the main developed economies. The European Central Bank, the Federal Reserve, and the Bank of Japan have all announced or expanded quantitative easing programs intended to support asset prices. We expect these interventions to eventually weaken their currencies against those of certain EM economies. Faced with abundant supply from central banks, major currencies such as the US dollar, the euro, and the yen, face downward pressure over the medium to long term. These major currencies are likely to depreciate against currencies of countries that do not face the need for deleveraging, and thus do not have to print as much money. Emerging economies largely fall into this category, and their currencies should appreciate against the majors as sovereign balance sheets rebalance.
That said, while we are positive about the outlook for EM currencies over the medium to long term, they face two short-term headwinds. The first is that in a world prone to acute bouts of risk aversion, the flight to safety favors liquid currencies, not necessarily those with the best fundamentals. The second is that many export-oriented emerging countries fear that stronger currencies will compound already weak external demand, with central banks intervening to prevent appreciation. As a result, the trend of appreciation could be interrupted by periods of volatility. While investors should take these short-term considerations into account when structuring their exposure to different EM currencies, we believe that over time, long-term appreciation trends will emerge for most of them.
Equities riding on superior economic growth
Higher average EM growth prospects should also translate into higher average corporate earnings growth. This, in turn, should support equity market performance in the medium term. In the near term, however, uncertainty about growth can increase volatility. The IMF forecasts real GDP growth in EM accelerating to 5.3% in 2013 from 5.1% in 2012. The growth differential between emerging and advanced economies is also forecast to widen in favor of EM, to 4.1% in 2013 from 3.8% in 2012. Currently, we believe EM equity valuations are attractive on a price-to-earnings ratio of 10.7x 12-month-forward consensus earnings, compared with equivalent multiples of 14.0x and 14.4x for the world and the US stock markets.
Over a longer-term horizon, we think that EM will have the edge over industrialized nations with regard to equity investments. Rapidly rising incomes in the emerging markets are catapulting around a hundred million people each year out of poverty and into the emerging middle class. This has resulted in impressive economic growth and fast-growing markets for consumer goods. Western consumer goods manufacturers that already have a large market share in the emerging markets are one group that will profit from this growth. However, local consumer goods and service providers will also benefit from the extremely rapid growth of the middle class in these markets.
Corporate bonds a growing market
Another asset class for investors to tap into the EM growth story is EM corporate bonds. We believe EM corporate bonds’ valuations are not in line with their attractive fundamentals. EM growth is on an improving trend this year and should benefit EM corporate bonds, which are of a relatively cyclical nature. Furthermore, given improved economic prospects and lower trending financing costs, EM corporates have registered lower credit default rates over the past five years compared to US corporates. We expect this trend to continue as emerging economies undergo a cyclical rebound. At the same time, EM corporate bonds’ relatively short duration offers some protection against rising US Treasury yields. In fact, we are not fundamentally concerned about the outlook for EM corporate debt, as we do not expect policy rates in the US to be raised over the next 6-12 months. We expect a base case return of around 2.5% in USD terms over the next six months.
EM corporates have overtaken sovereigns as the main issuers of new USD-denominated EM debt since 2003. While increasing leverage can become a risk concern at some point, we believe the asset class is still in a healthy growth mode. As EM corporates have markedly improved their balance sheets in recent years, they have gained better access to capital markets, which has improved the liquidity profile of the asset class. Yet, EM corporate bonds trade at a discount to developed market corporate bonds of equivalent credit fundamentals.
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