A key attraction of emerging markets is their dynamism. They are emerging. They are changing – sometimes quickly, sometimes slowly.
China’s inland provinces may still be underdeveloped, but the same is hardly true of Shanghai or Guangdong. Meanwhile, governance in China has arguably not developed at the same pace as the economy.
Australia is not classified as an emerging market and its governance would generally be ranked highly. But its economy is biased toward commodities and its trade is oriented to China.
South Korea is included among EMs, but its per person GDP is about the same as Spain and higher than that of the EU as a whole.
Despite these differences, which some might see as anomalies, EMs do still behave within certain broad patterns.
Through most of 2018 EMs struggled as investors became increasingly convinced that US interest rates would continue to rise at least to the end of 2019 and possibly further.
The first half of this saw a distinct turnaround. There have been two key factors behind this change.
One is the return to a more dovish monetary policy in both the US and Eurozone, including the admission that winding down central bank balance sheets is likely to be slower than planned.
By suppressing returns in developed markets, this helps to push investors to seek better returns in higher risk sectors, not least EMs.
The other factor favouring EMs is greater confidence that global growth remains reasonably stable, particularly in the US and China.
These two economies, the first and second largest in the world, are by far the most important markets for EM goods and services.
The stable fundamentals of many parts of the EM sector, together with economic policy credibility, have been further factors supporting good performance.
Finally, cheaper valuations at end-2018 across many markets drove a large pick up in investor inflows.
Currency drag
EM performance has not been universally positive, however.
EM sovereign credit (specifically, hard currency bonds issued by governments) has delivered the strongest returns, albeit with a few more challenging country-specific situations such as Argentina and Turkey.
The strength of the US dollar, which helped lift hard currency outperformance, was a drag on the performance of local currency assets.
According to JP Morgan, EM equities rose 12 per cent in US dollars in the first four months of 2019 – a solid return, but below levels seen in the US and Europe.
An issue often overlooked by EM investors is the influence of factors.
Traditionally, despite EM economies being driven by value-biased sectors such as materials and commodities, in aggregate they were all about growth.
Today, the sector mix is broader and more various, with technology and financial among the most important.
This offers active managers a wider and more interesting opportunity set.
It can also mean managers riding on a winning style, such as ‘growth’ or ‘value’.
It might look like the outperformance is coming from stock selection, while in practice it is coming from the market more generally favouring a particular style tilt.
The chart shows that for much of the past three years, growth has massively outperformed value.
A manager whose approach was to invest in growth stocks, in companies that have higher earnings and cash flow than the market, is likely to have been rewarded above and beyond their skill at picking stocks.
Conversely, managers whose investment philosophy consisted of investing in undervalued companies might have struggled, even where they were identifying excellent long-term opportunities.
Growth management
Given the market’s preference for growth, client cash flows have moved to funds with a growth bias.
This is not necessarily a bad strategy. But investors should be aware of where their returns are coming from and understand how the style tilt might impact their experience in the future.
Key points
- EMs are attractive because of their dynamism
- EMs are all about growth
- Growth outperforms during up markets, but does not fare so well during down markets
There are two particular caveats to bear in mind.One is that growth tends to outperform during up markets, but to fall more heavily than value in down markets.
The second is the broad cyclicality of the two styles. During the second half of 2018, in response to the view that US interest rates were rising, valuations on the growth side of the market tended to fall, while the relative performance of value rose.
Timing these rotations is fiendishly difficult. Even where the timing is right, value as a style tends to outperform in relatively limited spurts, often only a handful of days in a year.
The most sophisticated investors struggle to capture such fine, though important, movements.
A skilled active fund manager may offer a factor bias as part of a total return, but advisers should be careful not to pay for alpha to receive a factor. Alternatively, a manager might control the balance of factors to focus pure alpha returns.
Away from the near-term market and trading outlook, we continue to see EM allocation as an important part of most investor’s portfolio mix.
EM countries represent an increasing share of global growth, yet their weightings in global bond and equity indices is well below this ‘economic’ contribution.
Historical concerns regarding governance remain, despite EM as a whole having improved greatly in terms of economic policy, transparency and state institutions.
It is these residual concerns that provide the higher risk premium carried by many EM assets relative to developed markets, and a well-structured exposure to EM can benefit from this.
Nick Davis is active sales specialist at Vanguard
