Insight

How can investors approach emerging market investments?

How can investors approach emerging market investments?

The term “Emerging Markets” (EM) is widely used by investors, but “Global South” has gained traction only since the Ukraine War. “EM” came into vogue in the 1980s, when the failure of state-led growth models to keep up with Developed Markets (DM) caused major geopolitical shifts. Reintegration of China, Russia, India, South Africa, Central Europe and Latin America into global markets began, hence, emerging markets. But newly coined “Global South” is an explicit demarcation between the “West”, committed to democracy and capitalism and willing to trade mainly with “like-minded” countries, and the “Rest” with diverse political and economic systems. Today, geopolitical and geoeconomic conditions are shifting back to state led development, consequentially raising questions about how to approach EM.

Macro factors distinguish DM, EM, Frontier economies
Macro factors distinguish DM, EM, Frontier economies

Note: Map based on a cross-section Principal Component Analysis of socio-economic indicators for 2023 of 175 countries: Invesco Blue, high-income “Developed Markets”. Mid-Blue, middle-income “Emerging Markets”. Cool-Blue, low-income, less diversified “Frontier Markets”. Dark-Blue, insufficient data.

Source: World Bank World Development Indicators

While most asset classes have defined names that capture their characteristics, EM is an amorphous and evolving category. It includes China, which is at the technological frontier; India, with cutting-edge services but not manufacturing; Brazil, whose economic cycle is linked to commodities; small/mid-sized economies highly integrated into DMs – Mexico, Poland; commodity exporters and importers, Argentina and Turkey. There are also sub-asset classes – equities; hard-currency sovereign and corporate credit; local currency sovereign debt; convertible, non-convertible, floating, managed and fixed currencies. Is EM really a cohesive asset class, given a wide range of indexes against which portfolios are measured? Should investors instead approach EM not as a whole but by sub-categories or individual allocations like many DMs? The best answer from a financial-markets perspective, in our view, probably lies in between. 

The phrase Emerging Markets acknowledges reemergence of “developing countries” into one world from a geopolitically and geoeconomically trifurcated world: First World (advanced industrialized market economies); Second World (centrally-planned communist countries) and Third World (middle-/low-income countries – mostly former European colonies). Reforms, such as creation of financial markets, privatization, deregulation, expansion of international trade and investment, were key to increased unity of those emerging economies. Arguably, the shift began with China’s opening-up and market reforms from the late-1970s; gathered steam in Latin America, with sovereign debt restructurings and liberalization. EMs expanded after the Soviet collapse and India’s near financial collapse, both in 1991, as the Gulf War drove oil prices sharply higher, kicked off the end of autarky in Eastern Europe and South Asia. Thus, by the early 1990s, all of Asia, Europe and the Americas were reintegrating for the first time since WWI.

Today, this “Washington Consensus” of liberalization is reversing, at least to some degree, including in the US itself. Rising trade and investment barriers might de-link economic cycles. Industrial policies in DMs and EMs to support selected industries, even firms, may differentiate trend growth. Monetary policy cycles are already diverging, from the ongoing easing in China to the start of DM easing, with other EMs in different phases. Do these geopolitical and geoeconomic changes argue against an EM-wide approach on a macro fundamentals basis? Again, the best answer is likely in between.

From an economic perspective, “EM” remains highly relevant with strong differences in socioeconomic indicators of growth, productivity and standards of living. From a financial-markets perspective, the story is more nuanced. EM fixed income returns are becoming more systematic, probably due to the global post-pandemic/post-war inflation shock and monetary tightening. Yet, EM equity is becoming more idiosyncratic/country-specific, suggesting that evolving growth and trade dynamics are influencing national stock indices. This in turn could pave the way for EM fixed income returns to revert to more idiosyncratic behavior, as in past global policy cycles when inflation was more stable regardless of the US policy rate levels or dollar strength. We take the view that the EM category and asset classes are becoming increasingly diversified by macro and financial performance drivers, calling for active strategic allocation with a macro beta-driven approach for tactical or cyclical allocation. 

Sub-asset class returns are ~50-75% systematic %

Note: Chart, time-series PCA analysisii of rolling 60-day USD total returns for select EM sub-asset classes using major indices (MSCI EM for equity; JP Morgan for fixed income).

Source: World Bank World Development Indicators, MSCI, JP Morgan, Bloomberg, Macrobond, Invesco, latest available data as at 14 June 2024.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Footnotes

  • i

    Principal Component Analysis is a statistical technique used to recognize patterns in large data sets, whethe cross-sectional across a sample at a given point in time, or in a time series of data. The approach is agnostic as to the underlying direction of causality and the identification of dependent and independent or causal variables. List of economic and social indicators:

    Mortality rate, under-5 (per 1,000 live births)

    Life expectancy at birth, total (years)

    Fertility rate, total (births per woman)

    Current health expenditure (% of GDP)

    Imports of goods and services (% of GDP)

    Exports of goods and services (% of GDP)

    Inflation, GDP deflator (annual %)

    GDP per capita (current US$)

    Labor force participation rate, total (% of total population ages 15+) (modeled ILO estimate)

    Adjusted net national income per capita (current US$)

    Government expenditure on education, total (% of government expenditure)

  • ii

    Here, PCA-I is used to assess the evolving proportion of shared or systematic behavior in time series of total returns (as a proxy for market beta, or alternatively, for available alpha). The rest is idiosyncratic (a proxy for “alpha”), though the first principal component of the returns of the country constituents of total-return indices across the main EM sub-asset classes (local currency, sovereign hard currency debt, corporate hard currency debt and equities). The higher the PCA-I value, the greater the “beta-ness”, as all countries within the index tend to move together in total return space more than they move individually on an idiosyncratic, country-specific basis. Conversely, the lower the PCA-II value, the greater the “alpha-ness” of the asset class – that is, the more alpha is available to be harvested, in principle, through country selection or diversification, due to greater country-specificity or idiosyncratic behavior in total return performance. 

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