Jason Simpson | Portfolio Manager
Emerging Markets (EM) have come a long way as an asset class during the past two decades. Once regarded as equities reserved only for the brave, it is now an important part of a diversified portfolio. Previously, EM investors often faced the perils of debt defaults, collapsing currencies and runaway inflation that stymied economic growth. Though risks still abound—as they do with all asset classes—the rewards of investing in EM can outweigh the risks. As the unprecedented events in 2020 continue to unfold, the current environment has uncovered positive factors that affect EM and it may be prudent to give the asset class a deeper look.
Lower Valuations = Attractive Entry Point
Relative to both its U.S. counterparts and historical norms, EM securities appear attractively valued. In the U.S. equity market, stalwarts within the technology, consumer discretionary and health care sectors have led domestic market returns year-to-date. These outsized gains have pushed U.S. equity market valuations to levels not seen in 20 years. On the contrary, thus far in 2020 we have witnessed the coronavirus pandemic spark a mass exodus out of EM in favor of less risky assets, resulting in depressed valuations abroad.
Source: JPMorgan, Guide to the Markets, International Equity Earnings and Valuations
Appealing Growth Prospects and Less Dependency on Commodities
Prospects for EM point to the asset class maintaining growth projections above the global economy. With EM currently comprising upwards of 60% of global GDP, its impact on global growth exceeds Developed Markets. As history has witnessed massive industrialization and urbanization of China, low-margin factory production and labor-intensive jobs are leaving that country in favor of more industrialized countries. This allows the labor force of other EM countries to move up to the middle-class and find their footing within developing markets. As a result, consumer spending should be a catalyst to regional economic growth and subsequently boost global GDP.
Over the years, EM countries have become less dependent on commodity-oriented sectors as technology and consumer sectors have assumed greater importance. For example, energy and materials comprised nearly 30% of the MSCI Emerging Market Index in July 2009; it is now less than half that. To be sure, some of the reduction in weighting stems from the poor performance of these commodity-oriented sectors over the past few years. But it is also true that EM companies have become an important part of global technology supply chains, and EM consumer companies are benefiting from rising middle-class incomes.
Source: International Monetary Fund, World Economic Outlook, June 2020 Update.
Source: International Monetary Fund, World Economic Outlook, June 2020 Update.
Weakening Dollar
Generally speaking, a weaker dollar (and EM currency appreciation) is often viewed as a favorable development for EM assets as dollar-denominated debt becomes easier to service, and U.S. dollar investors benefit from appreciation in EM currencies on top of any changes in securities prices in local currency terms. Markets witnessed the U.S. Dollar Index (DXY) peak at the end of the first quarter 2020 and it has since declined nearly 10% following monetary and fiscal policy measures enacted to quell global coronavirus pandemic fears. Should extended weakness in the dollar continue, EM stocks may be an attractive option for investors seeking higher-yielding opportunities.
What are the risks?
Given the current environment, EM can present compelling opportunities in a diversified portfolio. Valuation levels, growth prospects and a weakening dollar all highlight the attractiveness of the asset class. While attractive, make no mistake – risks within EM remain. Much of the effects of the initial coronavirus outbreak on EM economies remain largely unknown, and uncertainty still abounds with fears of a second wave in the months ahead. EM countries will need to continue enhancing their infrastructure and governance systems to regain solid economic footing. Meanwhile, geopolitical tensions between the U.S. and China are not getting better. Ahead of November’s U.S. presidential election, it is reasonable to expect intensifying rhetoric with China, which comprises nearly 40% of the EM index today, increasing from 17% in 2010 and 9% in 2003. During the worst of the trade war, EM and particularly China underperformed the U.S., which given current weightings has a greater impact on the overall index than it did just 10 years ago.
Finally, it is important to remember that EM equities remain a highly heterogeneous asset class–the impact of any single factor or event will be extremely different depending on the country in question; every EM country has been dealing with the COVID crises differently and their economies are in different stages of recovery with varying capacity for fiscal or monetary stimulus. Understanding these nuances and country-specific economic profiles is important in assessing the growth trajectory of EM equities.
Nonetheless, compelling opportunities in EM securities remain over longer time horizons and should be considered as an appropriate allocation in a diversified investment portfolio.
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This material is for informational purposes only and is intended for current or prospective clients. This information is obtained from believed to be reliable sources, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice, and does not consider individual investor circumstances. Actual results could materially differ from the results indicated by this information. Past performance is not a reliable indicator of future results.
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