Emerging markets offer great investment opportunities. But with so many countries and asset classes to choose from, Nick Martindale explores what the starting point should be for those looking to invest

With most occupational pension schemes firmly in the red and traditional markets remaining volatile, it is perhaps understandable that investors are looking further afield for the prospect of half-decent returns. Emerging markets, in particular, appear attractive, both in the potential they offer for growth but also as antidotes to otherwise sluggish conditions.

“From a macro perspective, now is certainly a good time for investors who have a desire to globalise their portfolios and a tilt towards growth to consider such a strategy,” says J.P. Morgan Asset Management client portfolio manager, emerging market debt, Rob Stewart. “Developed markets are clearly struggling to reach positive trend growth as they are battling excess deficits and debt levels, and the fundamentals for emerging markets are significantly stronger.” Emerging markets’ economic growth will be four times that of developed markets this year alone, he adds, and will contribute around 50 per cent of global GDP.

BlueBay Asset Management senior portfolio manager David Dowsett identifies Eastern Europe and Asia – led by a surge in Chinese growth – as potential hotspots for 2013, along with a number of other ‘newer’ emerging economies. “We now believe we are starting to see positive signs from emerging market data that some of the economies are returning to growth, with improvements in leading indicators in Mexico, Brazil and Columbia,” he says. “In Brazil, which has had the most policy stimulus, we are increasingly confident that we should see a notable improvement in growth.”

The BRIC countries in general look good value in the current market, says J.P. Morgan Asset Management portfolio manager, emerging market equities, Claire Peck, having undergone something of a correction recently. But she warns of the need to take a more diversified approach, rather than just relying on such markets. “Generally speaking, investors should start with a core global emerging markets strategy, then diversify out into regional or single country exposure, and only then start looking at specialist strategies like smaller companies and frontier markets,” she says.

Other countries are also tipped to emerge as the next big areas for growth. Hermes head of emerging markets Gary Greenberg says bargains can currently be picked up in South Korea but also highlights the potential of ‘frontier markets’ such as Nigeria and Cambodia, while Wells Fargo Asset Management portfolio manager Derrick Irwin adds Turkey and other parts of south-east Asia to the list. “But while many of these countries do indeed offer interesting fundamental growth stories, we must be wary of both valuation and liquidity,” he warns. “Many of these markets are substantially less liquid than those in larger emerging economies, which can lead to inflated valuations and high trading costs.”

In many ways, however, the country is less significant than the type of asset class. Dexia head of emerging markets bond funds Luc D’hooge says emerging market bonds have delivered strong returns in the past few years and tend to provide a “nice diversification” to portfolios, while equities potentially offer greater reward in the current environment. “Over the last few years, emerging markets debt has been the place to be and has outperformed equities and foreign exchange significantly,” he says. “So the outlook for equities is probably better than for bonds, but it is a completely different risk. If you decide to invest in bonds, you have to temper your expectations because of the current yields. But emerging bonds are not expensive versus other bond markets.”

Equities are the current investment of choice for Cardano, says client director Phil Page, followed by currency and then debt. “This is different from 12 months ago, when we favoured currency over equities,” he says. “But the opportunities between countries vary by asset class. In some emerging market asset classes, like inflation-linked debt, a few countries are a large part of the market. In equity markets there are 15 or so credibly sized markets, each of which will vary in attractiveness over time.” All are likely to be in demand going forward though, he adds, along with corporate bonds, inflation-linked bonds and private equity, albeit that these are starting from a lower base.

Neuberger Berman head of investment strategy and risk Alan Dorsey also says equities are currently more attractive than debt, with the spread between the equity earnings yield and the bond yield to maturity in emerging markets at 10-year highs. “From a secular perspective, we anticipate that emerging market currencies will be increasingly seen as a store of value; a choice for foreign exchange reserve currency allocation,” he adds.

Another recent trend has been towards higher-rated sovereign credits in hard currency denominated debt and higher-quality local bonds, says Dowsett, particularly in countries where central banks have been able to cut interest rates without raising concerns over their ability to pay back debt. “In Brazil, for example, inflows have made their way towards the lower-risk part
of the emerging market marketplace,” he says.

In the longer term, however, the move is likely to be towards local currency bonds, particularly in corporate bonds, says Ashmore Investment Management co-head of research Jan Dehn. “The growth of this market is a natural extension of the emergence of deep, long local currency sovereign bond curves,” he says. “Global capital markets are increasingly recognising the global convergence process underway between emerging markets and developed economies and the best way to tap into this process is to take exposure to corporate bonds in emerging markets. For the first time, we are now seeing much more money going to the private sector than to the public sector in emerging markets.”

Record Currency Management head of economic research and FX strategy Javier Corominas also points to a shift from hard to local debt, pointing out that around 85 per cent of the US $7.5 trillion public debt in emerging markets is in local currency. “Concerns about emerging market debt are shifting from credit risk to more traditional interest rate risk,” he says. “At this juncture, yield compression in hard currency debt has gone quite far, and these bonds are also vulnerable to a normalisation of the interest cycle in the US; something local currency bonds are more immune to.”

Yet emerging markets by their nature tend to be slightly more risky than more established sectors, as investors are less familiar with the specifics. PTL managing director Richard Butcher says diversification is the name of the game. “The world is too large for any one fund to be able to build a portfolio of balanced assets, so investors need to keep exposure to a modest level and arrange access through a pooled vehicle,” he says.

One potential risk is that of environmental and social governance (ESG), and the possible damage that investing in less than scrupulous corporations or governments could do to investors’ brands and holdings. In the past service providers have hidden behind lack of demand as a reason to avoid conducting too much scrutiny into such concerns, says First State Investments global head of responsible investment Will Oulton, but this is starting to change.

“Increased asset owner exposure to emerging markets has resulted in an increase in demand to understand the investment risks from ESG factors,” he says. “Where emerging markets are concerned, relatively limited disclosures by companies compared to their developed market peers and weaker regulatory and legislative frameworks which, where they exist, are often not enforced require a higher level of scrutiny and engagement than for similar developed market portfolios.”

Yet if investments can stand up to such criteria, emerging markets could play a significant role in helping trustees and organisations repair damaged funds over the years ahead. “Much of the developed world is experiencing structural headwinds that will be a drag on growth for an extended period of time,” says Irwin.

“Many emerging markets remain in substantially better shape structurally, still have significant room for monetary and fiscal easing, and few have debt levels as high as those in the developed world. While markets have been buffeted by macroeconomic news flow in recent months, making security selection challenging, we think it remains a good time to invest in emerging markets.”

Written by Nick Martindale, a freelance journalist

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