Investment opportunities in emerging markets

We expect a widening growth differential, lower valuations, and secular trends in the coming decade to favor emerging markets.

by Mark Haefele, Chief Investment Officer, UBS Global Wealth Management

The re-emergence of emerging markets

The economic and social changes in emerging markets (EMs) over the past two decades have been extraordinary. EM countries now make up over 60% of total global economic output and account for over 70% of global GDP growth. They consume the majority of the world’s oil, copper, and iron ore as well as the bulk of global car sales and cell phone subscriptions. Since 2000, over one billion people in emerging economies have moved out of poverty, while the number of billionaires has increased more than three times faster in EMs than in the developed world.

Investors exposed to these developments have been well rewarded. In recent years, however, the EM story has changed. EMs failed to shine between 2014 and 2019 as their aggregate growth advantage over developed markets (DMs) shrank. Investors, tired of the underperformance, have voted with their feet. However, we think that emerging markets currently offer some of the most attractive investment opportunities globally.

Why invest in emerging markets

Relative growth set to pick up

We expect the growth differential between emerging and developed markets, which has historically been closely tied to emerging market performance, to widen in EMs’ favor. The low current growth differential partly explains why
EM equities have underperformed DMs in recent years, but the outlook is more positive.

We forecast that the growth differential between emerging and developed economies will increase from its recent plateau of around 2.5ppt toward 3.5ppt this year. This EM growth outlook is supported by benefits to manufacturing from a Phase 1 trade deal, accommodative central bank policy, and our expectation for a weaker dollar this year.

Earnings trends favor EMs

Valuations in emerging markets are lower than in developed markets. However, given that valuations across almost all markets are above 10-year averages, and near early 2018 peaks, we think that earnings instead are likely to become the primary driver of returns going forward. This dynamic should favor EM equities.

Regionally, we expect 2020’s highest rates of earnings growth in Asia ex-Japan and Latin America. Over the next decade, we expect much lower DM equity returns—about 4–6% nominal returns per year in local currency terms. But in EMs, we expect roughly 9% annual returns in USD terms, largely thanks to better potential for longterm profit growth.

EMs in the decade of transformation

Many of the greatest identifiable secular trends in the coming decade of transformation will play out in emerging markets. Consider water scarcity: Given an imbalance between population and access to freshwater resources within EMs, we expect continuous revenue and profit growth for the entire water value chain.

Moreover, the expansion of megacities in EMs is driving demand for infrastructure investment. We also believe public investment in healthcare in EMs will pick up due to aging populations. And we expect the combination of 5G, artificial intelligence, big data, and cloud computing to define a new era of digital transformation and innovation.

How to invest in emerging markets

We hold an overweight position in EM equities. In our FX strategy, we also add a preference for the Brazilian real to our existing EM currency basket which also includes the Indian rupee and the Indonesian rupiah. That said, we now see less of an opportunity in EM hard currency bonds and close our overweight position there.

We are monitoring the coronavirus risk closely, and at this time do not believe it warrants portfolio action.

See our preferences for additional asset allocation guidance.

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