The role of emerging markets in a diversified investment strategy
Marcelle Murphy from Advance explores the role of emerging markets in a diversified investment strategy.
After standing tall as the lynch-pin of growth during the global financial crisis (GFC), emerging markets (EMs) appear to be falling from their pedestal.
Investors, flush with cheap capital, eyed the prospects of EMs as being more attractive than those of developed markets such as the US, Europe and Japan.
However, the US Federal Reserve (the Fed) has announced the tapering of its record stimulus policy and this, accompanied by some faltering growth prospects in the world’s key EMs, has created the prospect of reduced global liquidity and is precipitating a flight of capital from these countries.
In the short term, the outlook is in a relative sense weak and full of challenges. However, longer-term economic prospects remain positive, suggesting that EMs should be an integral consideration for investors, with diversification remaining the key.
The status quo
Emerging markets, (nations with accelerating social or business activity, during the process of rapid expansion and industrialisation), have experienced a fast pace of economic growth over the past decade to 2012.
The growth of Gross Domestic Product (GDP) in these markets averaged 6.4 per cent, compared with just 1.7 per cent in the advanced economies.
It was exceptionally strong in 2010 (7.5 per cent) and 2011 (6.2 per cent), thanks to the strong capital inflows from the developed world where historically loose monetary policy in the wake of the GFC prompted investors to search for higher returns elsewhere.
In addition, solid domestic credit expansion directed by governments to finance investment and consumption growth significantly contributed to this growth.
The financial backbone
It’s estimated that almost US$9 trillion of capital flowed into the world’s EMs over the past four years. Ample financing has been available at cheap rates and combined with favourable demographics, the conditions have proven to be very conducive to facilitating strong economic growth.
On the back of this, investors were duly rewarded for taking the plunge into EMs, which proved to be the best performing asset class over the past 10 years.
The MSCI Global Equity Indices (which provide equity market coverage for over 75 countries in the Developed, Emerging and Frontier Markets) returned an annual average of 16.1 per cent, compared with developed market equities (4.8 per cent), global bonds (7.7 per cent) and global property (5.3 per cent).
The average also holds its weight in comparison to 7.7 per cent for the Barclays Global Bond Index and 5.3 per cent for Global Property.
The reign of debt
Unfortunately, the downside of this strong growth trend is a massive build-up of gross debt in these countries.
The increased availability of credit at low rates encouraged rapid increases in borrowing, initially feeding much needed investment in housing and industry, but eventually fuelling speculative investment.
As such, many countries are now running massive current account deficits and face historically high debt-to-GDP ratios.
This was not an issue while global interest rates remained low, and their currencies were strong, but now with the prospect of higher global bond yields and increased pressure on EM currencies, EMs are weakening as capital starts to flow back out.
The Indonesian, Indian and Brazilian currencies have been particularly hard hit, plummeting by 18 per cent, 13 per cent and 14 per cent respectively since the beginning of May 2013. For most EMs, this essentially means that servicing their debt becomes much more difficult, and raises the risk of default.
New policy measures
Some EM governments have been forced to adopt policy measures that aren’t necessarily in line with growth to offset the impact of a potential default.
This has certainly been the case recently in India, Brazil and Indonesia where their central banks raised official interest rates as their currencies plummeted against the US dollar and inflationary pressures continue to rise.
However, growth has already been slowing and, as such, prospects for these economies over the coming year look subdued compared to the strong growth they’ve exhibited in recent years.
The challenge in China
China remains the significant factor in relation to the EM outlook, and still faces its own challenges. Strong domestically-driven credit growth was instrumental in accelerating investment-led economic growth, which reached more than 8 per cent in recent years.
However, the fallout of this has been overcapacity and very high local government debt. It’s estimated that China’s debt to GDP ratio could reach almost 250 per cent of GDP by 2015, so for China to absorb this overcapacity its economy will need to ensure that growth remains very solid.
The diversification approach
In general, fundamentals remain quite positive for EMs, but the prospects do differ amongst countries, and this is where potential investors need to focus on diversification to gain the biggest benefit from EM investment.
The five major emerging national economies – Brazil, Russia, India, China and South Africa (BRICS) – are now at a more advanced stage of their economic and financial development and as such, their periods of extremely strong growth are now behind them.
However, other economies are yet to follow.
The EM growth engine
EMs are expected to continue to be the growth engine of the global economy over the coming years.
BRICS may be coming up against constraints but others continue to have favourable demographic trends (ie, younger populations), which means as their economies develop, so too will their middle classes, which will grow and enable consumers to buy more goods as their quality of life improves.
As such, the current slowdown in many of these economies should prove to be just a blip in the longer term. Still, underdeveloped accounting standards – along with the different levels of currencies, politics and laws of the EM countries – are all risks that can lead to more volatility.
When taking into consideration that EM economies contribute half of the world’s GDP and are still on an upward growth trajectory, yet still only account for around 10 per cent of overall global stock market capitalisation, the potential for stronger returns is clear.
Marcelle Murphy is the economist at Advance Funds Management, an asset management firm owned by BT Financial Group.
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