How to achieve diversification within emerging markets

But if macro factors have the capacity to determine both the sentiment, and the reality, of emerging market equity performance, how can an investor create a portfolio that is diversified enough to capture the variety of opportunities from the set of economies which are becoming an ever greater part of global GDP. 

Dominic Bokor-Ingram, senior portfolio manager at emerging market specialist Fiera Capital, sums this up as: “Emerging markets are less an asset class than a series of events. The macroeconomic environment of the whole world matters much more than in other asset classes, and that means you have be very selective when investing there.”

Two of the themes that tend to dominate the discourse around emerging markets are the relative strength of the dollar and the outlook for commodity prices. 

Investors shouldn’t just focus on Asia when thinking about their exposure. There has started to be a trend in markets of thinking that you can forget the rest.Daniel Hurley, T Rowe Price

In 2022 Latin American equities were the best-performing sector in the Investment Association funds universe, as commodity prices rose. 

Jonathan Toub, fund manager at Aviva Investors, says: “Commodity demand over the longer-term is usually driven by the level of demand from China, it is hard to get away from that. But in terms of areas that are diversified from the wider story, the gulf states are becoming an increasing part of the market.”

Daniel Hurley, emerging market specialist at T Rowe Price, says one major change in recent years has been the capacity for higher commodity prices to negatively impact other emerging markets, notably India and China, which are consumers of commodities.

China is around one-third of the entire emerging markets index, so if commodity prices negatively impact the growth of that country, that has an impact on the rest of the emerging market sector.

Arun Sai, senior multi-asset strategist at Pictet Asset Management, says Brazil as a commodity exporter and China or India as commodity importers perform totally differently from each other depending on where commodity prices are, and this offers investors the opportunity to diversify within emerging markets.

Hurley says the capacity for emerging market economies to benefit from higher commodity prices means: “Investors shouldn’t just focus on Asia when thinking about their exposure. There has started to be a trend in markets of thinking that you can forget the rest, but I think the performance of Latin American equities in 2022 shows they have a role to play.”

Fahad Kamal, chief investment officer at Kleinwort Hambros, says he is generally quite sceptical on the investment case for equities right now but is overweight emerging markets. 

His principal reason for having this view is valuation: “Emerging market equities have never traded as cheaply relative to developed markets, except for maybe two occasions in history. For us, the valuation case offsets the negatives. Emerging markets tend to move in long downswings and long upswings.”

Almighty dollar? 

Investors tend to be sceptical of the investment case for emerging markets when the dollar is strong, even though such a view is no longer justified by the evidence, according to Sai.

Traditionally, emerging market companies and countries must borrow in dollars, rather than their own currencies, and when the dollar rises, this is often a function of US interest rates rising, and that pushes up the cost of debt repayments, leaving less for shareholders and bond holders in emerging market assets.

For us, the valuation case offsets the negatives. Emerging markets tend to move in long downswings and long upswings.Fahad Kamal, Kleinwort Hambros

Additionally, US interest rates rising typically leads to a slowdown in global growth, and as many emerging market economies are exporters, this harms the returns available. 

Sai agrees that investors continue to avoid emerging market assets when these factors are present, but says it is no longer justified.

Winds of change?

One of the reasons Sai says it is no longer justified to treat emerging market assets as inversely correlated with the dollar is the growth of the middle class in emerging markets, meaning developed market consumption matters less, while the increased levels of savings among those populations means there is greater capacity for companies and countries to raise finance in their own currency.

Sai adds that Asian (excluding Japan) equities no longer trade at a “beta greater than one” to global equities, meaning that the performance of those equity markets is no more correlated with the performance of the global economy than are developed market equities. 

Kamil Dimmich, emerging market equity investor at North of South, says: “If you look at the performance of emerging markets last year, they only fell about the same as developed markets.

"And within that a number of emerging market economies performed strongly, and the index as a whole was dragged down by China; countries such as Taiwan have big budget surpluses and so are net exporters of capital. The strength of the dollar doesn’t particularly impact them.” 

Bokor-Ingram says emerging market countries are generally less indebted now than are developed economies, and that even if emerging markets are more sensitive to a global recession, “the valuations arguably reflect this, with emerging market equities trading at a discount of around 20 per cent relative to developed markets.”

One of the consequences of a stronger dollar is that emerging market central banks often have to put interest rates up in order to keep pace with the dollar, even if this has a detrimental impact on the growth potential of their own economies. 

But Charles Bond, emerging market equity investor at Invesco, says several emerging market central banks put up interest rates prior to the US Federal Reserve hiking their own base rates, and this meant the impact of subsequent rate rises on emerging market economies was much less severe than was the case historically. 

David Thorpe is investment editor at FTAdviser