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Asset AllocationJune 23, 2022

‘More Slowly and With a Narrower Focus’

Institutional investors are still placing long-term bets on emerging markets despite recent volatility.

Art by Jonathon Rosen

It’s been a hard few years for emerging markets. The pandemic cut off economic activity, and reopening efforts have been complicated by vaccine procurement difficulties, rising inflation and war. According to Bloomberg data, the emerging markets sector has as investors weigh the risks and opt to head for the exits.

Volatility appears likely to remain elevated in listed stocks and bonds. Robert “Vince” Smith, CIO at the New Mexico State Investment Council, says his outlook for listed emerging markets exposure is less constructive than it has been for a number of years. NMSIC has a mix of private and public exposure to emerging markets. NMSIC’s emerging markets strategies are all actively managed— which enables a more tactical, opportunistic approach .

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“For most of my career, we invested in emerging markets for growth, but today a lot of that has changed,” he says. “Globalization is slowing down and I think we’re on the downslope of the globalization cycle we have been in for several decades. That’s going to be hard for emerging markets companies.” Smith adds that if NMSIC were to make a change today it would probably reduce some of its exposure to listed emerging markets equities.

However, public markets don’t tell the whole story. While emerging markets stocks and bonds have been under pressure, there is still activity happening within the private markets. Institutional investors with long-term time horizons are still betting that these markets will make it past the current slate of challenges.

Pre-pandemic, institutional investors were opening up offices in emerging markets and setting up teams to invest in funds and make direct investments. All of that is still happening, albeit at a slower rate and with a narrower focus. Rather than chasing consumer-driven trends, institutions in emerging markets are choosing private markets projects that align with long-term themes.

In April, Ontario Teachers’ Pension Plan Board announced a US$175 million investment into KKR’s road platform in India—a portfolio of 12 road assets including a mix of toll and annuity roads. This was the third infrastructure investment Ontario Teachers’ made in India, following its 25% stake in the National Highways Infra Trust late last year. Ontario Teachers’ is also an anchor investor in the National Investment and Infrastructure Fund, India’s first infrastructure-specific investment fund.

Now, Ontario Teachers’ is reportedly considering opening an office in India as early as next year to continue its investment activities on the subcontinent. If the pension decides to open an office there it will be the second Canadian pension to do so. The Canada Pension Plan Investment Board opened a Mumbai office in 2015.

ESG Takes Center Stage

ESG goals are also factoring into how institutions approach emerging markets. At the start of this year, Dutch pension provider APG invested $750 million to anchor a new fund launched by ILX Management, ILX Fund I, which will make direct-impact private-sector loans in emerging markets; the loans will be targeted to the United Nations’ Sustainable Development Goals and arranged by international development banks.

The private credit fund will support emerging markets loans in four areas: energy access and clean energy; sustainable industry and infrastructure; inclusive finance; and food security. Each of these areas maps to the Sustainable Development Goals.

ILX Management is supported by Cardano Development, a fund incubator focused on local currency-financing strategies within emerging and frontier markets. ILX got initial grant funding to develop its approach from the Federal Ministry of Economic Cooperation and Development (KfW) on behalf of the German Ministry for Development Cooperation (BMZ), the Netherlands’ Ministry of Foreign Affairs and the U.K. Foreign, Commonwealth and Development Office. The firm intends to raise additional institutional private capital for SDG loans and climate finance investments in emerging markets.

A consortium of U.K. pensions is working on a similar strategy. In May, the Church of England Pensions Board along with Brunel Pension Partnership; Border to Coast Pensions Partnership; BT Pension Fund; Environment Agency Pension Fund; NEST; Northern LGPS; Legal and General Mastertrust; Legal and General Workplace Pension Plan and Stakeholder Pension Plan; Railpen; Universities’ Superannuation Scheme Ltd, and West Yorkshire Pension Fund created a group representing almost £400 billion in assets that will work on identifying investment opportunities that support the climate transition in emerging markets.

In a statement on the effort, Rachel Elwell, CEO of Border to Coast, said that the goal of the group was to coordinate with emerging markets to identify ways those countries can meet the climate goals set forth in the Paris Agreement. The group will deliver its action plan at the upcoming 2022 United Nations Climate Change Conference, commonly referred to as COP27, in Egypt in November.

This month, Singapore-based Temasek launched its own S$5 billion climate-focused investment platform, GenZero, to accelerate decarbonization globally. “Achieving net zero globally will require the deployment of around US$5 trillion annually by 2030, to rapidly adopt and commercialize sustainable energy solutions,” said Dr. Steve Howard, chief sustainability officer at Temasek International. “GenZero will not only support Temasek’s efforts as we strive towards halving our portfolio’s net emissions by 2030 and working towards a net zero portfolio by 2050, but also those of the wider ecosystem.”

Many of these projects are also investments in the real economies of emerging markets countries, which have shown resilience even if global listed markets remain volatile.

Asian Development Bank Senior Economist Shu (Grace) Tian notes that throughout the ASEAN+3 countries, many governments and private sector companies are looking at ways to further develop the regional sustainable bond market because of the growing interest in ESG investing. She expects that over the next three to five years the sustainable bond market in ASEAN+3 will continue to grow in size. “There is a recognition that the sustainable bond market can deliver performance and is aligned with the SDGs,” she says. “We are working on a regional standard that will be aligned with international standards so that we can lower the barriers for international investors that have SDG initiatives.”

ASEAN governments—like other emerging markets—were ahead of developed market central banks in raising rates and taking steps to stabilize regional local currency bond markets over the past several months. Those efforts have given ASEAN countries more room to maneuver and focus on long-term plans like supporting sustainable bond issuance. “Even though financial conditions have tightened, the economic fundamentals throughout much of the ASEAN region remain strong,” Tian says.

Institutional Investors Take a Cautious, Long-Term Approach to Emerging Markets

Supply chain struggles, ongoing pandemic-related disruptions and a growing anti-globalization mood are adding to the challenges for developing market investing.

By Beth Braverman

Art by Jonathon Rosen

After a decade in which emerging markets returns lagged those of the American stock market, many institutional investors say that emerging markets securities continue to face significant headwinds.

Those headwinds include challenges posed by the ongoing pandemic and the slow recovery of global supply chains. In addition, emerging markets are up against rising anti-globalization sentiment, a strong U.S. dollar and the Russia-Ukraine war.

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“The events have created the most heterogeneous environment we’ve seen in a decade with unique country monetary, fiscal and pandemic policies,” says Carlos Rangel, vice president and CIO at the W.K. Kellogg Foundation. “In general, developed markets provided more stimulus and support. We are tracking currencies as a near-term adjustment mechanism, differentiating between EM commodity importers versus exporters, inflation stress points, and tracking who wins if U.S. companies manufacture less in China over time.”

The trends impacting emerging markets have created a difficult environment for investors interested in allocating capital to less developed economies. China, the world’s second-largest economy, has seen a significant economic slowdown amid a Covid Zero policy that continues to mandate disruptive lockdowns.

“It has really been close to a perfect storm of macro elements impacting emerging markets,” says Doug Cohen, a managing director and portfolio manager with Fiduciary Trust International. “The basic question has become whether these countries are really investable. For the time being, Russia is indisputably uninvestable. With China, there’s more room for debate and, on balance, one could look to have some China exposure. It would be imprudent not to have some.”

Cohen also has a muted outlook on eastern European countries, given their proximity to Ukraine and Russia. But other emerging markets countries, including some in South America and the Middle East, look more interesting by comparison, Cohen says.

Opportunities Over the Long Term

He’s not the only one who sees opportunity in emerging markets.

“Maybe I’m an optimist, but valuations in emerging markets continue to remain attractive over the long term,” says Brian Neale, CIO at the University of Nebraska Foundation. “From a valuation perspective that creates opportunity, but it creates some challenges as well.”

One of those challenges is inflation, not only in terms of economic impact, but also because of its potential impact on the political stability of those countries, Cohen says, citing the Arab Spring, which started, in part, due to inflation and rising food prices.

Despite the challenges, emerging markets investors say the long-term outlook for emerging markets securities is a good one.

“If I were to take a 10-year-plus view and look at where we are valuation-wise, not that much has to go right for emerging markets to outperform,” Cohen says. “There is a reversion to the mean argument, especially if you are somewhat diversified, given country-specific risk.”

Sticking to the Plan

At the New Jersey Division of Investment, the emerging markets allocation target remains at 5.5%, a level that has not changed in recent years, says Shoaib Khan, its director and CIO.

“We are slightly under target, but we are not that far from it,” he says. “We are in a bit of a defensive position across the board because of volatility in the markets, but we continue to remain constructive over the long term.”

Neale says he’s also staying the course in terms of allocation, which he says he can do thanks to a perpetual time horizon, as well as other portfolio factors, including ample liquidity elsewhere.

‘The Next Best House on the Block’

Peter J. Klein, CIO at Aline Wealth, sees emerging markets opportunities with active investments in places like India, Thailand, the Philippines, Mexico and Latin America.

“I’m having a tough time with the China exposure,” he says. “There are some great companies there that are cheap, but I have some concerns, so I’m looking for the next best house on the block.”

In particular, Klein says, he’s bullish on India due to several factors, including its transition to a national market and its expansion into renewable energy. He also likes its preeminence in information technology and the way that the country is gaining a foothold in supply chains that were previously rooted in China.

A Local Focus

When looking at emerging markets investments, Klein says he generally prefers companies focused on their local markets versus companies seeking business globally. Such companies benefit from positive demographic trends in those the countries.

“If you look at Japan, and the United States, and Europe, we are an old persons’ home,” he says. “Emerging markets are where the young people are. It’s where they’re going to be working and producing, not taking retirement benefits.”

In addition, many emerging markets countries have a rising middle class, which boosts demand for infrastructure, and a growing consumer base.

“These are all long-term, structural trends that will continue despite the short-term cyclical events,” Khan says.

Companies focused on local markets have delivered better returns than those looking toward global expansion, Rangel says.

“In the last five years, we’ve seen more regional success stories as companies solve common pain points across EM countries by region and founders have bolder visions for their companies.”

A Challenging Debt Market

Rangel says he does not have a mandate in emerging markets debt and does not plan to add one in the medium term.

“It is our view that the [foreign exchange] overwhelms the fixed-income decision,” he says. “At best, emerging markets debt would be a multi-month, tactical view expressed via ETFs or swaps.”

Klein says he stopped investing in EM bonds more than a year ago, preferring to keep a portion of his portfolio in cash, despite the negative real returns. In his view, bond investments aren’t worth the interest-rate risk.

Cohen has a similarly bearish outlook on emerging markets debt.

“It’s a difficult backdrop for fixed income generally, and when you layer in emerging market risks like inflation and geopolitical shocks and the potential for liquidity markets, it’s very difficult to be bullish on emerging market bonds as a whole,” he adds.