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March 21, 2017

Why we invest in Emerging Markets

Most investors are familiar with the standard arguments in favor of  Emerging Markets (EM) such as a higher growth potential and diversification benefits. However, we see three further reasons that justify an investment in EM: (1) the EM investment universe is much more attractive today than it was 10 years ago, (2) EM are less crisis prone nowadays and (3) EM valuation is attractive relative to developed markets.

Not your father’s EM index

Would you prefer to have a higher weighting in high-growth tech stocks or in the low-growth and capital intensive energy & materials sector? The MSCI EM Index has seen a significant shift in its index composition over the last 10 years which makes it more interesting to allocate to EM now in our opinion.

  • 10 years ago, energy & materials accounted for more than 30% of the index, today it is only 15%
  • 10 years ago, the tech sector accounted for only 13% of the index, today it is 24% and thus the largest sector. Incidentally, the tech sector has now a higher weighting in the MSCI EM index than in the MSCI USA index (22%) or the MSCI Europe index (a paltry 4%).

Finally we shouldn’t forget that most companies in the energy & materials sector are state owned enterprises. They tend to be less efficient and rarely have foreign investors on top of their mind. For both actively managed funds and index funds (ETF), EM represent a better investment universe today.

EM have become less prone to crisis

Make no mistake: every region is prone to cycles of boom and bust. EM are still riskier than developed markets. However, today EM are less likely to exhibit the same severe crisis as they did 10-20 years ago. There are mainly three important reasons why we are seeing now less of the old doom-loop:

  • No more original sin. EM sovereigns used to borrow in US Dollar but collect revenue mostly in local currency. This mismatch was called “original sin”. Now an overwhelming majority of their funding comes from local currency instruments.
  • More corporate debt than sovereign debt. Historically, EM sovereigns were the biggest issuer of debt, now a large part of borrowing takes place at the corporate level. In the event of a crisis, this is less damaging to the overall system because the consequences are now easier to manage.
  • Deeper local markets. Over the last 10 years, EM have developed a much deeper financial sector. There are now large domestic pension funds, insurance companies, mutual funds, sovereign wealth funds, etc. EM are less reliant on foreign funding. The domestic financial sector has its own steady inflows and can act as a shock-absorber on its own.

Valuation matters

Valuation drives performance. Today, most equity, credit and bond markets in Europe and the US are not cheap. On the other hand, EM are trading at a significant discount.

Equities (2017 forecast):

 Emerging Markets
MSCI Emerging Markets
USA
S&P 500
Europe
EuroStoxx 600
P/E multiple12x18x15x
Dividend yield2.6%2.0%3.5%
GDP Growth4.5%2.3%1.6%

Bonds:

 Emerging Markets
Barclays EM Local CCY Government Bond
USA
10 year US treasuries
Europe
10 year Euro AAA bonds
Yield6.4%2.5%1.3%

Summary

I lived in Latin America and worked in Asia for a couple of years for a global investment bank. However, seeing EM first hand has rather made me more cautious about investing in EM. In the past, I often felt there was simply too much hype relative to fundamentals! Today, the picture has changed and we have been overweight in EM in our clients’ accounts for some time now. Year-to-date, the MSCI Emerging Market index is up +9% (in US$), far outpacing developed equity markets in Europe and the US.

What is our preferred way to get exposure to Emerging Markets? While many investors have so far reflexively reached for EM hard currency bonds (mainly in US Dollar), we believe this is NOT where you will find the best risk/reward in this coming cycle. If you would like to know which EM assets fit into your long-term asset allocation plan, please don’t hesitate to get in touch.

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