Emerging market assets have always been a source of both potential profit and peril for investors. 2022 saw an incredible streak of capital inflows into emerging market equities, bonds and currencies. Whilst returns are still characteristically volatile, this historically maverick asset class has become old and resilient than in the past, as was highlighted during February’s market sell-off.
The promise of fully capitalising on potential upside growth during bull markets is ultimately the important thing appeal of allocating capital to EM. From 2002 to 2007, the MSCI Emerging Markets Index had an annualised return close to 30% in comparison to the MSCI World Index which returned around 17% over the same period. The powerful growth continues through the nine-year bull market because the global financial crisis, with the index returning over 100%.
Back when emerging market equity indices were first formed, the outlook for EM equities was heavily dependent on rates and currencies. Today, this really is no more the case. When the MSCI Emerging Markets Index premiered in 1988, it accounted for just 1% of the global market capitalisation. This figure is now over 13% because of the enormous development of the countries it captures in recent times. The actual drivers of growth have also changed and several countries have ‘grown-up’ to now show fundamental characteristics much like some countries of the developed world which is highlighted within the beta coefficient of emerging market indices. The MSCI Emerging Markets Index currently has a three-year rolling beta of just beneath 1.2 using the MSCI World Index, a figure which has fallen from the high of almost 2 in 2007.
A major factor in the functional decrease in the beta coefficient recently has been the growing similarity between your sector allocations of EM and DM equity indices. It is striking that both the MSCI Emerging Markets Index and the MSCI World Index have Information Technology and Financials because the largest two sector weights. Adding EM equities to some portfolio alongside developed equities resultantly no more adds the strong sector diversification it once did. Nevertheless this does not make emerging markets redundant his or her inclusion still adds significant country diversification towards the portfolios. The MSCI Emerging Markets index, for example, allows investors to achieve contact with the development drivers of 24 unique and dynamic economies.
A simple method of achieving contact with the potentially explosive growth and strong regional diversification of EM would be to invest in a passive investment creation that tracks a benchmark of EM equities. Ever since EM became viable as an asset class, the number of arbitrage opportunities presented whilst stock-picking in EM space has been diminishing, mainly because of increased analytical coverage and also the general growth and development of the countries themselves. Resultantly passive EM products have risen in popularity and capture a lot of the inflows into EM assets today. Exchange-Traded Funds , only one type of passive investment wrapper, are estimated to have captured 23% of the c. $1 trillion total net inflows into emerging markets in 2022.
The recent sell-off was fascinating to observe. In the past when investors have aggressively sold equities, the performance of EM equities has been incredibly poor due to its historically high beta. This has made investors generally fearful of EM assets due to the high downside risk once the going gets tough. However, now we saw EM equities outperform DM equities both throughout the sell-off and also the bounce back. This encouraging performance suggests that factors apart from the cyclicality of equity financial markets are now more pressing when considering holding EM. These include the basic principles from the countries within the asset class rather than the performance of equities like a broader asset class.
From a macro perspective, EM assets look very sound in our opinion. The aggregate fundamentals of emerging market countries continue to improve despite political uncertainty , volatile currency rates and sanctions affecting several countries individually. We are seeing robust growth coupled with low inflation in major EM countries that have historically experienced high inflation. Additionally, global trade is increasing and fixed investment into EM is forecast to get through the next couple of years driven by developing demographics predominantly in the form of a rapidly growing middle class in the key Asian EM countries.
EM economies and businesses have incredibly varied growth paths available, as well as exclusive access to vast and growing consumer markets. As long as this is the case, emerging markets will remain a distinctly different asset class with other equity regions along with a viable investment opportunity alongside developed assets in a diversified portfolio.
Whilst we see growth potential in EM equities being an asset class we are wary of the functional Chinese exposure the index provides and appreciate that a 'hard landing' from the Chinese economy is a tail risk worth hedging against. Recent headlines indicating a potential trade war between your US and China have emphasised the need to hedge from the risks associated with China. In the portfolios we are currently underweight the broad EM equity index, balanced by selective contact with Mexico and India.