Is it time to go back into emerging markets? Institutional investors certainly think so. They have poured money into emerging market stocks and bonds at a near-record rate this year.
With the IMF predicting that the global economy is likely to do better in 2023 than it thought even a few months ago, emerging market bulls say this could be a good moment to look again at developing economies and their hopes of catching up with the industrialised world.
But the bears wonder if it is really the right time to return to markets that are less predictable than most, at a time of considerable geopolitical uncertainty.
The question is particularly tricky for retail investors who may lack the resources properly to research markets that are often remote and opaque.
“We feel there is value in seeking out the better value countries and regions in emerging markets — but you have to go in with your eyes open,” says Mark Preskett, senior portfolio manager at investment management and research firm Morningstar. “It’s very easy to get it wrong and for a country to stay out of favour for years.”
Too often, emerging market assets are buffeted by global storms that neither governments nor corporate executives can do much about. But for savers who can ride those waves and stay invested in a diversified portfolio for the long term, the returns can be rewarding.
FT Money takes a look at whether readers should dive in or keep their feet firmly on the shore.
Varied and volatile
If evidence was needed that emerging markets are volatile, last year delivered it in bucketfuls. For the first nine months of the year, foreign investors — mostly big institutions such as pension funds, banks and insurers — fled emerging market stocks and bonds on a scale never before seen in the history of the asset class — not since western investment managers made their first significant inroads in the 1980s.
But in October everything changed and investors flooded back in. Since early 2023, the benchmark MSCI Emerging Market equities index has been trading 20 per cent or more above last year’s low — meaning it is back in a bull market.
Does this volatility reinforce the message to retail investors that they should stay away? Or is this upswing a sign of a sustained recovery offering even those investors who buy now plenty of profit? Even after the recovery, EM equities are still about 30 per cent below their peak in February 2021.
Preskett at Morningstar says retail investors should take a cautiously positive view. “We would see emerging markets almost as a core asset class, where your weighting depends on your attitude to risk.”
Many retail investors, he notes, will already be exposed to emerging markets through funds that track global equity indices. The widely followed MSCI All Country World Index, for example, has about 11 per cent of its weight in emerging market stocks, including 3 per cent in China alone. (Some would say those weightings should be larger: China’s weighting is less than that of either Apple, at 3.7 per cent, or Microsoft, at just over 3 per cent.)
Yet, José Mazoy, global chief investment officer at Santander Asset Management, says private investors should take great care in venturing any further, and “only make investments that fit their risk profile”.
Emphasising that his concerns extend beyond emerging markets to the overall outlook, he adds: “In the context of globally diversified portfolios, we remain generally cautious on equities.”
Prospective buyers should bear in mind that, given the extra volatility, EM forecasts can go wrong far more spectacularly than mainstream market predictions.
High rates hit hopes
Just 12 months ago, many analysts expected 2022 to be a good year for the asset class, as coronavirus lockdowns and travel restrictions were lifted.
Russia’s full-on invasion of Ukraine changed all that, even though some commodity exporters temporarily benefited from sharply rising prices. Even they were hit soon after by the effects of rising global inflation, climbing interest rates and a strengthening US dollar. Few analysts anywhere had expected the yield on benchmark 10-year US Treasuries to more than double from less than 2 per cent in February to more than 4 per cent by October.
High US rates and a strong dollar are anathema for emerging market investors. As the rewards offered by safe-looking assets such as US Treasury bonds rise, and the dollar appreciates, investing in emerging markets looks less appealing.
Nor were Ukraine or the dollar/rates combination the only factors in a difficult year. Paul Greer, portfolio manager for EM fixed income at Fidelity International, says the “absolute nadir” came in October with “the whole episode of fiscal chaos in the UK” under shortlived prime minister Liz Truss, combined with the Communist party congress in China, which suggested that president Xi Jinping would stick with his hardline zero-Covid policies.
UK fiscal turmoil matters to EM assets because it bears on investors’ willingness to take risks, especially for the many fund managers based in the UK.
China’s zero-Covid policies — and China’s economy more broadly — matter much more. Since it joined the World Trade Organization in December 2001, China’s fast-growing economy, with its soaring demand for materials and manufactured goods from other developing countries, has been another big driver of EM performance.
But China’s growth, running at more than 10 per cent a year in the early 2000s, slowed to less than 6 per cent in 2019 and just 2.2 per cent in the first pandemic year of 2020.
Growth rebounded to 8 per cent in 2021 but then Xi’s zero-Covid policies sent it tumbling again to 3.2 per cent last year. The IMF does not expect much of a bounce back — it forecasts growth of less than 5 per cent a year for the next four years.
Not surprisingly, the MSCI China dollar-denominated equity index lost almost two-thirds of its value between mid February 2021 and the end of October 2022. This was bad for emerging market equities more broadly, with Chinese stocks making up a third of the MSCI Emerging Markets benchmark index.
But soon after last October’s nadir, Truss quit and Xi delivered a 180-degree U-turn. At the same time, signs began to emerge that global inflation could be near its peak and that the US Federal Reserve would soon slow the pace of its interest rate rises.
Investors sensed an opportunity and jumped on it. Chinese stocks rallied, recovering a third of their losses, and lifted the MSCI Emerging Markets index as investors poured in.
A sustained recovery?
So what next? Jahangir Azia, an analyst at JPMorgan, says there is “a lot of gas in the tank” for further funds inflows given that interest rates, the dollar and the Chinese economy are all now moving in EMs’ favour.
Moreover, after some time in the doldrums, emerging economies are once again set to grow faster than the advanced world. JPMorgan economists expect GDP in emerging markets to grow by 1.4 percentage points more than the rate in advanced economies this year, up from zero in the second half of 2022.
The IMF’s latest revisions give EMs a further boost. It says that while the pace of GDP growth in advanced economies will slow this year, emerging and developing economies turned the corner last year and will grow by an average of 4 per cent this year and 4.2 per cent in 2024, up from 3.9 per cent in 2022. That compares with just 1.2 per cent in advanced economies this year and 1.4 per cent in 2024, down from an estimated 2.7 per cent in 2022.
The prospect of accelerating growth in emerging markets is a welcome change for EM assets. Ever since the 2008 global financial crisis, many emerging economies have struggled to replicate their strong pre-crisis growth.
On top of this, a clear slow down in the prolonged surge in investment into US tech stocks means risk-on investors are looking for alternative growth opportunities.
“I firmly believe there is only so much investment capital to go around and it has all been channelled into US growth stocks,” says Preskett at Morningstar. “If we do get a change in this perceived exceptionalism of US growth stocks, capital might start flowing the other way and be attracted to emerging markets.”
For EM bulls, it’s a heady mix of positives: falling inflation and interest rates; a weaker US dollar; a recovery of growth in China and, by extension, in other emerging economies, and large amounts of investment capital looking for a new home.
But if they do rise, not all emerging markets will rise together. The days when the Brics — Brazil, Russia, India, China and South Africa — were expected to drive global growth and investment returns in lockstep are long gone. Russia has self-destructed as an investment prospect. South Africa has failed to live up to its promise. Other EM groupings — Civets, Eagles or Mints, anyone? — have come and gone as countries have increasingly followed more diverse economic paths.
Under Morningstar’s projections for the next 10 years, the countries with the highest expected equity market annual returns are all in emerging markets: Brazil (12.9 per cent), China (11.1 per cent) and South Korea (10.4 per cent), with the highest projected returns in developed markets in fourth-placed Germany, at 9.6 per cent. By comparison, Morningstar expects the UK to return 7.8 per cent and the US, 3.5 per cent.
Also, some EM equity valuations are low, offering a good entry point — as long as they then recover. For example, Brazilian equities are at about 7.3 times forward earnings, well below their 10-year average of 11.3 times.
But would-be investors should note that after their recent surge, Chinese stocks are not so cheap — the FTSE China equity index trades at about 10.7 times projected forward earnings, just below the 10-year average of 11.2, according to S&P Capital IQ.
Greer at Fidelity International says: “It will be a bit more incremental from here on. We may have seen the lion’s share of the rally in this cycle.”
As always in emerging markets, expect volatility. None of the factors in their favour is permanent. Unexpected shocks may come, as they did, in dramatic fashion, last year.
In Preskett’s view, most retail investors have yet to be convinced, despite the recent market recovery and the favourable prospects. “This is a very unloved rally,” he says. And it is easy to see why. “If you read the headlines, you should be staying away.”
Experts’ emerging market tips
For institutional investors, stock markets are dwarfed by bond markets. But retail investors focus on equity markets, where long-term returns have traditionally been greater.
Also, emerging market bonds can be especially risky, by fixed-income standards, given a history of sharp swings in interest rates and exchange rates. And because EM bonds and stocks are more closely correlated, EM bonds do not offer the diversification provided by advanced economy bonds.
Dzmitry Lipski, head of funds research at Interactive Investor, the investment platform, says 2022’s EM equity price swings demonstrate the “significant risks” but also the “attractive opportunities” for long-term investors.
Be “very cautious and selective”, he says. Interactive Investor recommends an allocation of just 10 per cent to EM equities in its model growth portfolios.
His picks include: Utilico Emerging Markets Trust: invests in infrastructure and utilities, mainly in Asia, Latin America, emerging Europe and Africa.
M&G Emerging Markets Bond fund: invests in government and corporate bonds, split about 70/30, in local currencies and US dollars. Top countries include Brazil, Indonesia, South Africa and Mexico.
Stewart Investors Global Emerging Markets Sustainability fund: buys EM mid-to-large-cap companies focused on sustainable development, aiming for long-term capital growth. Half the portfolio is invested in technology and consumer staples, with almost 70 per cent in emerging Asia.
Laith Khalaf, head of investment analysis at AJ Bell, also likes the Stewart fund. His other choices are:
Fidelity Emerging Markets: run by the experienced Nick Price and a strong team who seek quality growth companies.
Lazard Emerging Markets: focused on attractively priced large-cap companies with robust profitability.
Morningstar’s Mark Preskett recommends an equity income and a bond fund:
JPM Emerging Markets Income: this targets higher dividend-paying stocks, offering an attractive yield and the total return potential of investments in the developing world.
L&G Emerging Market Markets Government Bond (Local Currency) Index: an index tracker fund offering a low-cost means of accessing emerging market bonds. The current distribution yield is a useful 5 per cent.