Flowering Among the Ruins: Why Emerging Markets Are Poised for a Revival

Art by Marc Rosenthal

Emerging market (EM) investments haven’t done a lot of emerging lately. They lag behind the developed world’s indexes amid the pandemic’s crippling spread. Still, there’s strong evidence that the varied nations comprising this sector will stage a good rebound in the year’s second half, or shortly thereafter.

“We believe the asset class is poised to deliver strong absolute and risk-adjusted returns” later this year, Lazard Asset Management predicted in a research report. As catalysts to this upturn, the firm and other Wall Street strategists point to commodity price hikes, higher inflation, a weaker dollar, and rising vaccination rates. Institutional investors should benefit from such a comeback because many have maintained a decent EM allocation despite the uninspiring results of recent times.

This asset class has been through many peaks and troughs. The MSCI Emerging Markets Index has clocked a draggy 1% performance thus far this year through Monday, while the S&P 500 has returned 16.9%. Part of emerging markets’ problem has been the large weight (37.5%) China occupies in the EM index. If you back out China—which only makes sense, some argue, as it’s the world’s No. 2 economy—then the benchmark improves to 8.4% for this year, which still is not much to brag about, relatively speaking.

No one denies that investing in an emerging nation brings a large dollop of risk. After EMs started to take off in the 1990s, investors got a wicked jolt of this downside. In 1997, debt-burdened Thailand devalued its currency, thus setting off a chain reaction that spread throughout East Asia and rocked the entire financial world. Then, a year later, Russia defaulted on its own enormous debts, with similar cataclysmic reverberations felt globally.

In the 21st century’s first decade, all of that seemed like a bad dream best forgotten. EMs romped and typically blew past the MSCI All Country World Index (ACWI) and the S&P 500. The buoyant thesis about these developing economies was that, because they had so much room to grow, they would be superior choices for the long haul. Well, that was then. Next came the 2008 financial crisis, and EMs never quite got their wind back. Not helping was the end of the commodity supercycle in 2015, and many EM economies are based on commodities. Right now, the Delta variant outbreak threatens to crimp recovery in Asia’s manufacturing hubs. For the past 10 years through June 30, the EM index logged a 4.3% annual return, versus 9.9% for the all-world measure.

Allured Allocators

Notwithstanding such unpleasantness, North American allocators continue to find EMs appealing. David Swensen, the celebrated chief of Yale’s endowment for more than three decades, first showed other institutions the wisdom of unconventional investments, and EM was high on his list. Swensen, who died in May, believed that proper diversification required investors to venture far beyond the confines of traditional stocks and bonds. As of its most recent report, Yale had 6.5% of its portfolio devoted to emerging markets equity.

Swensen’s influence and the growing excitement surrounding EM investments convinced many allocators to secure positions in the sector. At the California Institute of Technology (CalTech), allocators began plugging money into EMs in the 1990s. “That was an opportunity to lean in,” said CalTech’s managing director, public and alternative securities, Douglas MacBean. Today, the endowment has about 15% of its assets in the category, a lot in public securities, some in private. The fluctuating fortunes of these investments don’t trouble MacBean, who stresses a long-term outlook.

To be sure, the EM slump in recent years has moved some allocators to proceed more cautiously in that arena. The Teacher Retirement System (TRS) of Texas, which has looked at opening a Singapore office, has had exposure to emerging nations for years. Amid dropping EM valuations, said CIO Jase Auby, TRS today  is “neutrally positioned” toward the category now. The EM price “discount appropriately reflects the [countries’] slower exit from the negative economic effects of COVID,” he reasoned. But TRS hasn’t cut back on its commitment. As of its last report, from the end of March, it had 9% of its assets in EM.

Canadian allocators, as is their wont, has put a strong emphasis on international strategies, with a significant focus on EMs. For instance: Air Canada’s pension fund has gotten involved with private credit in India. Many of the Canadian public funds are heavily into infrastructure. British Columbia Investment Management (BCI) and other investors have acquired an Indian telecom tower company in a $3.4 billion transaction. Caisse de dépôt et placement du Québec (CDPQ) has offices in Singapore, Mexico City, Shanghai, Sao Paolo, and Delhi, hunting for opportunities. Solar energy projects in India are one example. “In order to execute good deals in a given country, I think you need people on the ground to have a local footprint,” Emmanuel Jaclot, executive vice president and head of infrastructure, told us last year.

For some institutions, notably the smaller ones, overseas offices and active investing are beyond their reach. They prefer investing in EM indexes, which passively track the category. For instance, Rhode Island’s State Investment Commission as of mid-2020 had 4.6% of its portfolio in an EM equities index, according to its annual report. “We recognize the importato the global economy” of developing nations, said Andrew Junkin, CIO at the state’s Office of the General Treasurer. But “we don’t look to be overweight or underweight the index.”

A bright spot for EM investors has been fixed income. The worldwide popularity of US Treasurys, for their safe-haven status, has produced price bargains and high yields in relatively neglected EM paper, said Jeff Grills, head of emerging markets debt at Aegon Asset Management. Sovereign debt for EMs can fetch around 7.5% in yield, he added.

The Comeback Case for EMs

For investors, it’s heartening that there’s an incipient turnaround in the fortunes of EM investments. EM countries rest their hopes on the US, Europe, and China as markets for their goods. The US and those other giant importers likely will provide sufficient demand, assuming global growth keeps going. EMs “want to export their way to success,” observed Cameron Brandt, EPFR’s research director. And it looks as if they will be able to.

Pandemic. Meantime, many virus-afflicted EM players are slogging through the latest outbreak of coronavirus. COVID-19 has slammed what used to be called Third World nations, in particular Brazil, India, and Southeast Asia. Vaccination levels are half those of developed countries. Nonetheless investors remain optimistic, at least for the moment.

As of Monday, Brazil’s stock market was up 2.9% and India’s 10.9% for the year. Indonesia (stocks ahead 2.5% year to date) and Vietnam (spurting 20.7%) are among those imposing lockdowns that have shuttered some factories and slowed the supply chain. The Association of Southeast Asian Nations (ASEAN), a 10-country Southeast Asia group that also includes the likes of the Philippines and Thailand, has seen its Purchasing Manufacturers Index slump below 50, a sign of contraction. Their governments have vowed to speed up vaccination rollouts.

Brazil, South America’s largest economy, benefits from increased demand for its raw materials—soybeans, oil, iron ore, wood pulp—a welcome offset to its high unemployment and chronic inflation, an annual 8.4% in June. A Reuters poll of economists expects the country’s gross domestic product (GDP) to expand a solid 5.1% this year. India, home to a thriving tech industry, also appears likely to surmount the new virus wave, with the International Monetary Fund projecting a 12% economic upswing this year. “After an initial shock” from the new virus outbreak,” EPFR’s Brandt said, “India’s GDP is growing.”

Another EM victim of the pandemic has been Thailand’s once-vibrant tourist industry, which usually contributes 20% to GDP. The tourism wipeout was a key part of the economy’s 6.1% contraction last year, with this year not much better. Tourists will return, albeit not as soon as expected, the government says. At the same time, its stock index is ahead 5.2%.

Commodities. The S&P GSCI Commodity Index has more than doubled since its April 2020 nadir. “This is a great tail wind for emerging markets” said Rand Wrighton, lead portfolio manager for EM strategies at Barrow Hanley Global Investors.

This matters mostly to Latin America and Africa, as Asia is more reliant on manufacturing. Places such as Russia are oil-dependent, although they do have notable industrial bases. Demand is rising for commodities, particularly oil. With the agreement to enlarge output by the Organization of the Petroleum Exporting Countries (OPEC) and a Russia-led alliance, oil prices have climbed 51% this year. That has been an elixir for nations such as Angola.

Dollar. The US currency has nudged up a bit this year, although the greenback is still way down compared with pre-pandemic levels. That’s a boon to EMs, because commodities are priced in dollars and the buck is the world’s reserve currency, meaning that it’s the means of exchange for international trade. As a result, EM exports get cheaper in dollar terms, a condition that spurs more goods purchases. What’s more, EMs that borrowed in dollars find servicing their debt cheaper.

Inflation. By the same token, climbing prices help EMs for the simple reason that their exports fetch more money. Rising inflation also is a sign of economic growth and signals that developing lands will be buying more. The drawback, to be sure, is the risk that inflation gets out of hand, unbalancing a nation’s economy. Argentina, long beset by runaway inflation, demonstrates this. For the 12 months trailing through July, inflation spiraled more than 50%, and analysts consequently are downgrading their projections for the country’s GDP growth.

China Syndrome

China’s current travails are the biggest remaining head wind for emerging nations. Because China is such a large presence in MSCI’s EM index, it has an outsized impact on the rest, both in terms of the MSCI benchmark and as a buyer of the raw materials. China’s growth trajectory has downshifted lately. GDP increased 7.9% in the April through June quarter from a year earlier, down from the more robust performance—18.3%—in this year’s first period. No surprise, its stock market performance is suffering. The Shanghai Composite has lost 0.3% this year through Monday’s close.

Supply shortages, and pollution controls are hindering China’s industrial activity. Fresh concern is brewing over COVID-19 outbreaks. More than a year and a half after the virus appeared in China—followed by the world’s first big wave of the plague—the country is again struggling to halt the spread of new cases from the more infectious Delta variant. The latest outbreak was first discovered in the eastern city of Nanjing, then the infections moved to 15 cities across the country, the South China Morning Post reported in July.

Chinese stocks’ underperformance, however, is partly self-inflicted. A potent drag on equities is the Beijing regime’s crackdown on private companies, chilling the animal spirits of capitalism. Stifling entrepreneurs such as Jack Ma may not be such a good idea, as they are a large force, propelling China’s spectacular growth over the past four decades.

The government has blocked the Shanghai and Hong Kong initial public offering (IPO) of the Ant Group, a financial services giant that Ma co-founded. And then the authorities hit ride-hailing company DiDi with a regulatory onslaught after the outfit’s New York IPO. Last week, officials slapped two tutoring businesses with tighter regulation.

On the other hand, EM investors have been through far worse. Given their prospects, emerging markets should get their groove back. As Barrow Hanley’s Wrighton pointed out, now is a good time to buy: “The stock prices are depressed—they’re cheap.”

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