No balanced portfolio would be complete without an allocation to EM assets, says CIO.(UBS)

What is an emerging market?

Emerging markets are a diverse bunch, spanning markets in Asia and Latin America, as well as Europe, the Middle East, and Africa. For equities, MSCI identifies 24 emerging markets, comprising 1,382 companies and a market capitalization of around USD 6.4 trillion, at the time of publication.

While no single definition fits all emerging markets, the group is characterized by some combination of factors including less developed financial markets, weaker institutions, and more volatile business cycles. As a result, investors must be willing to tolerate greater volatility and risk to participate. Yet, no balanced portfolio is complete without an allocation to emerging markets, in our view, both thanks to the high return potential and the diversification benefits of such assets.

Why does investing in emerging markets make sense?
A definition of emerging and frontier markets can sound like a lengthy list of drawbacks. Institutional quality and liquidity are lower, while political risks are higher. This typically translates into higher asset class volatility. The MSCI Emerging Market Index has posted annualized volatility of 21.5% on average over the past two decades, versus 15.4% for the developed nation MSCI World Index. EM sovereign and corporate bonds are also more volatile. So why should investors consider emerging markets as part of their portfolio?

Diversification: Emerging markets are an integral part of the global economy. But EM business cycles are not fully aligned with developed markets. For example, monetary policy in China has tended not to move in tandem with the Federal Reserve, and economic cycles have not been fully in sync. China’s economic and markets drivers have also been different than those of developed regions in recent years—including a tightening of business regulations in 2021 and longer-lasting COVID restrictions through most of 2022. The result is that adding EM to a portfolio adds diversification benefits. For example, MSCI China rallied over 50% from a low point in the fourth quarter of 2022 to early February, compared to a rise of 20% for the MSCI World.

Higher returns: Emerging markets tend to have faster economic growth, as they can adapt best practices, technologies, and policy initiatives that have worked in developed nations to aid their convergence in economic development. For example, in 2022 advanced nations grew by 2.7%, based on IMF estimates, versus 3.9% for developing economies. Emerging and developing Asian markets did even better, growing 4.3%. Several large emerging markets have become centers of innovation in their own right—especially mainland China, Taiwan, and South Korea, which have burgeoning technology sectors.

Interest rates in these regions have trended lower over the years—thanks to improvements in the way these economies are managed and a downward trend in inflation—supporting returns in EM bonds. The 20-year average return on USD EM sovereign debt was 6.4% (with a volatility of 8.7%) versus 2.8% for DM government debt, based on the Bloomberg Global Aggregate. Compounded over a 20-year investment period, emerging market bond investors saw double the returns of those who constrained themselves to developed countries. We believe the developments that led to this outperformance are likely to persist.

Turning to equities: On the surface, the relatively modest return premium offered by emerging markets looks insufficient to justify the higher volatility. Since 2003, the MSCI EM has returned on average 9.4% a year— with a volatility of 21.5%. That compares to an average return of 9% for the MSCI World, an index covering developed equity markets, with a much lower volatility of 15.4%. But the asset class has provided periods of significant outperformance—most notably between 2003 and 2007, when China’s growing integration into the global economy generated a growth spurt and boosted demand for commodities. While we don’t see a repeat of this particular episode, we do believe conditions are right for another period of emerging market outperformance—as we will explain below.

The upshot here is that no balanced portfolio would be complete without an allocation to EM assets. Volatility is higher, but in exchange, investors gain access to some of the fastest-growing and most dynamic parts of the global economy. Adding emerging market assets to a portfolio can improve a portfolio’s efficient frontier—potentially increasing expected returns relative to volatility overall.

Why does this matter now?
In our view, current conditions for emerging markets have been improving—for stocks, bonds, and currencies alike. We see several supportive factors that favor a tactical overweight position, including:

  • The earlier-than-expected reopening of China looks set to boost domestic consumption, and demand for goods and services from other emerging (and developed) nations. Energy and other commodities are one area we expect to benefit, but also service spending, for example for tourism, and discretionary spending are likely to see a significant pickup in demand. Over the last three years, Chinese consumers could not spend as much as usual, leaving them with stronger balance sheets. Tactically speaking, China's reopening is important and will both directly and indirectly benefit emerging market assets through improved growth prospects, higher commodity prices, and improved financial conditions thanks to stronger currencies and lower interest rates.
  • We believe equity valuations are appealing on a relative basis and corporate fundamentals are turning the corner. At the time of writing, the MSCI EM index is trading at 12 times 12-month forward earnings—a small premium to its 10-year average. But that is still a close to 30% discount to developed markets. Earnings momentum and earnings revisions are still negative in absolute terms, but bottoming versus developed countries.
  • Emerging market bonds have also benefited from a range of tailwinds. These have included a decline in US inflation, a shift in China's COVID policy stance, and increased support for China's property sector. With these incrementally more positive developments, recession risks have declined or been pushed into the future. We note that the sovereign index yield is now around 8.2% and the corporate index yield is around 6.7%. The value in EM credit sits in the distressed segment. The more positive tone is allowing progress to be made on restructurings, and we think it provides some upside to prices and the overall EM complex.

For more, read the full report CIO tutorial: What are emerging markets? 10 February 2023.

Main contributor: Christopher Swann

This content is a product of the UBS Chief Investment Office.