Emerging Markets Stepping out of the Shadows

Source: JPM

The macroeconomic environment also continues to look more favourable than in many developed markets, where higher debts and fiscal balances loom large. Fiscal positions across many EM countries are comparatively robust, with greater policy headroom following lower post-pandemic spending, allowing for earlier or more proactive fiscal stimulus if needed.

Whilst uncertainty around US trade policy initially appeared to pose a structural challenge to emerging economies, trade flows have adapted, demonstrating the resilience and agility of EM supply chains. At the same time, the high correlation between US equities and bonds, coupled with concerns around market concentration, has encouraged global investors to diversify away from the US.

Risks

Emerging markets remain sensitive to shifts in investor sentiment or economic conditions and historically, oil supply shocks have not been kind to emerging markets. However, so much will depend on how long the conflict lasts, and what the world looks like afterwards in terms of inflation, ongoing tensions, the level of the dollar and recession risks.

Importantly, emerging markets have become less sensitive to oil prices over the years as benchmarks have leaned away from commodities and more towards technology, services and innovation. Whilst we should expect volatility in the short-term, the long-term case for emerging markets remains intact.

Investors are paying more for emerging market earnings, and those earnings are growing faster, making the re-rating more durable.

Implementation

We extensively reviewed the performance of actively managed equity funds over the long-term, against appropriate benchmarks, net of fees. What becomes apparent is that whilst returns from active managers have been disappointing, there are pockets of opportunity where active managers have tended to add more value and one of these areas is emerging markets.

From a structural perspective, there is weaker financial infrastructure, lower liquidity and trading volumes and less analyst and data coverage which has contributed to less efficient markets. Whilst, from a behavioural perspective, there is higher retail participation and the data shows that this investor base is more reactive to speculative trends, allowing for active managers to capitalise on price dislocations.

As such, within our MPS, we utilise some of our fee budget to allocate to one actively-managed emerging markets equity fund (Invesco Global Emerging Markets Fund).

The Invesco Global Emerging Markets Equity Fund provides an unconstrained approach to investing in emerging markets, looking to unearth companies that are trading at a significant discount to their estimate of fair value. The fundamental research process is rigorous, with a consistent focus on balance sheet strength, profitability and cash flow dynamics.

Since the current management team assumed responsibility in late 2018, the Fund has delivered strong outperformance versus both the MSCI Emerging Markets Index and its peer group.

Final Thoughts

Generally speaking, UK investors are under-allocated to emerging market equities compared to global peers. Whilst EM makes up c. 11% of the MSCI ACWI Index, emerging markets makes up c. 50% of global GDP. From this perspective, UK investors are structurally and cyclically underweight emerging markets.

At Isio, we think a meaningful allocation to emerging markets provides strong diversification benefits. Correlations across countries diverge frequently within emerging markets and this provides opportunity to diversify risk exposure, whilst the wide sector mix provides diversification benefits, as no single macro factor dominates returns.

As investors look to continue to expand beyond the US, we think an allocation to emerging market equities is an effective solution for increasing portfolio resilience and risk-adjusted returns.