Growing pains

So are we at the beginning of another emerging markets crisis, or will investors look back in a few years’ time and say 2014 was a great time to invest? That remains to be seen, but poor sentiment, attractive valuations, helpful demographic trends and a broadening investor base should bode well for investors with sufficiently long-time horizons.

There has been much discussion of a ‘mass investor exodus’ out of emerging markets, but just how significant have outflows been in the context of the overall asset base? The global mutual fund and ETF emerging markets flow data (see table) suggests, “not very”. Selling may continue, but outflows from dedicated emerging market equity and bond funds, estimated at about $28bn (£16.4bn) year-to-date, are little more than a rounding error in terms of total market size.

We should remember that emerging market assets have increasingly become a strategic allocation for pension funds and other institutional investors around the world. While recent gyrations serve as a useful reminder that emerging markets are volatile, it is doubtful that many institutional investors will be reducing their strategic allocations to these regions. If anything, after several years of relative underperformance, we expect many of these investors to rebalance their portfolios, perhaps resulting in flows back into emerging market assets throughout the year. ‘Hot money’ flows may make headlines, but the activities of strategic investors are more important over the long term.

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Figure 1: Global mutual fund and ETF emerging markets flows

Year-to-date flowsFund Assets
Equity funds-$17.9 billion$646bn
Bond funds-$10.2 billion$301bn
Source: Morningstar Direct, as of 31 March 2014. Global mutual fund and ETF flows.

That emerging markets have become an increasingly important part of the global economy is undeniable. According to the IMF, 2013 was the year in which emerging and developing economies overtook developed ones in terms of contribution to global economic output. This is remarkable given their collective share of the pie was only about 37 per cent in 2000. In equity market capitalisation terms, emerging markets have more than doubled from 5 per cent in 2000 to about 11 per cent at present. Additionally, there is little doubt that emerging market debt has become more accessible over the same period, with almost $700bn (£412bn) in dedicated funds and mandates. This means that emerging markets are currently too significant an opportunity for investors to ignore.

Although they have recovered a little recently, emerging market bonds and equities have struggled since May 2013, when Ben Bernanke announced that the US Federal Reserve would look to taper its regular bond purchase programme should the economy continue to improve. However, it was not just emerging markets that suffered. A range of assets sold off as they became relatively less attractive, suggesting that tapering does not explain the whole story behind recent emerging market under performance.

Emerging market equities have underperformed developed market equities in two of the last three years, cumulatively returning about 45 per cent less. In short, the underlying issues that have contributed to the emerging markets slowdown are not all driven by interest rates in the US. This suggests that rising rates in the US do not necessarily mean that emerging markets assets need to suffer.