In this debate series, GRI asked: With increasing political risks and instability occurring in spots such as Turkey and Brazil, is there still an appetite for investors to invest heavily in these emerging markets? Analyst Sagar Sambrani says the rewards are worth the risks. Read the opposing case here.
A phrase that sums up financial markets for the past few years has been “lower for longer”, which implies that some of the largest central banks in the world have been unable or unwilling to raise their record low interest rates even despite huge stimulus measures. 9 out of 10 market participants surveyed by CNBC in 2012 believed that the US Federal Reserve would begin its interest rate hiking cycle before 2014.
The only rate hike thus far has been one in December last year. Fast forward to Q3 of 2016, however, and are still eagerly awaiting any indication that the Fed may raise rates for the first time this year. Meanwhile, Japan & Europe, the two other large developed markets have pushed yields into negative territory to revive their economies, although any sustained positive impact remains to be seen. Commodity markets too have ended their multiyear bull run & yield hungry investors have had to scour global markets looking for new avenues to generate alpha.
In this “new normal”, where regular investments fail to meet return expectations, investors have begun to turn to emerging markets with sustainable strong growth prospects which are well poised to capture this opportunity.
Comparison of returns
A staggering $11.7 trillion worth of developed market debt is now negative yielding – i.e. it returns investors lesser value than they paid to purchase this debt.
Fitch Ratings estimates that such bonds create losses of over $24 billion per year in investor portfolios. Investors buying developed market bonds at negative yields have absolutely no yield cushion to compensate for capital losses once yields begin heading higher as the world returns towards normalcy.
In contrast, investors in dollar denominated bond ETFs (exchange trading funds) earned 11.5% by July this year & around 5% in each of the last 3 years, without facing any currency risk. An allocation of Emerging Market debt investments in an investor’s portfolio provides much-needed return on capital that can compensate for other “lower risk” assets such as bonds.
We must also consider the fact that these comparatively impressive returns have been obtained despite China, Russia & Brazil (three quarters of the BRIC nations) facing extremely challenging years, highlighting the potential return in better years. Comparing equity market returns, the MSCI Emerging Markets Index is up almost 15% in 2016 vs 4% for the MSCI World Index this year. Even after accounting for FX hedging costs, the EM index outperforms its global peer by a significant margin.
Despite the bigger rally in EM stocks, the MSCI EM Index is trading at a price to book value of 1.35, less than 50% that of the S&P 500 at 2.9. In terms of future outlook, the latest International Monetary Fund forecasts brought downgrades for developed economies, but not for emerging markets. The growth gap, which has been narrowing since 2011, is set to widen again.
Managing Emerging Markets & Developed Markets risk
Market reactions post-Brexit imply that market participants were under-prepared for the consequences. With a Brexit timeline unclear until Article 50 is enacted, investors in Britain and Europe therefore face tremendous uncertainty.
Not surprisingly, since the landmark voting day, we have seen an exodus of capital into emerging markets, including the largest four week EM inflows on record. Some of the largest investors globally, including hedge funds and asset managers, have been a part of this consensus too, signalling their belief that some EM majors currently provide a better reward to risk outlook than Europe does (Ray Dalios $150bn Bridgewater, for instance, is very bullish on India).
Analysing global macro risks, commodity prices have traded in a large range (crude oil between $27/bbl and $120/bbl) over the past few years. These moves have caused volatility in emerging markets. For example, India & Russia are both heavily dependent on oil prices. India is a large importer and Russia, a large exporter.
Moreover, when country specific risks plague an EM nation – the recent Turkey coup attempt being a case in point – investors have the option to reallocate positions within emerging market funds to continue earning high yields, and not necessarily pull capital out of the asset class altogether. Diversification has always been a key investor principle for optimizing risk return profile.
The risk of a sovereign debt default is another concern for overseas investors in EM. According to Bloomberg, as of June 15, 2016, more than 60% of the issuers in the iShares J.P. Morgan USD Emerging Markets Bond Index are rated Investment Grade. This number has doubled in the past 10 years on improving EM economies’ fundamentals and their ability to repay.
Also, for more risk seeking investors, EM High Yield bonds offer additional yield to compensate for negative yields in Japanese & Euro bond investments.
This year, the world also seems to have adjusted to China’s growth being below 7%, while markets are also currently pricing in the Federal Reserve’s second interest rate hike almost a year after its first. Both these concerns have died down, which has led to a sharp rally in emerging market assets.
This also somewhat reduces the threat of a stronger dollar that may reduce dollar yield. Currency hedging costs have fallen significantly too. Benign global interest rate policies seem here to stay, at least for the foreseeable future, and emerging markets provide the best opportunities to benefit in such times.
What do the world’s largest investors say?
Pimco and BlackRock, two of the world’s largest institutional investors, have both declared a positive outlook on EMs.
Francesc Balcells, emerging market portfolio manager at Pimco, says “Yes, trillions of dollars of developed market bonds offer negative yields and emerging markets offer positive yields, but you can also point to the fact that the worst of the recessions are over and the likes of Russia and Brazil are turning around. EM is still a risk asset class but the stars have aligned in such a way as to be encouraging.”
Richard Turnill, managing director and global chief investment strategist for BlackRock believes that the slow U.S rate hike cycle has afforded several EM countries such as India and Indonesia the time needed to implement key structural reforms that have bolstered their resilience in times of global strife.
Invest in the future
China has averaged 10% growth for almost two decades up to 2010 after it initiated market reforms. It may have been difficult for global investors to really enjoy this success at the time, but with globalization there are now multiple avenues to do so. With India, China & some other EMs continuing to beat developed market growth rates consistently, this is the time for investors to be a part of the growth stories of the next few decades.
A potential impact of Brexit could be the weakening of the Europe/US power bloc which had imposed economic sanctions against Russia. Russia, and even China, could stand to gain enormously, both politically & financially, and this could provide a great opportunity to long-term investors over the next decade.
For investors looking to generate alpha, emerging markets have proved to be a key component of their portfolio, owing to the impressive relative yields compared to developed markets & opportunities for hedging through diversification across EM. Understanding of EM risks has improved over the years with globalization and investors are now better poised to navigate these waters and extract the yield they seek.
GRI Debates provide critical insight into the world’s most challenging political risk topics. Through well-balanced opinion based articles, GRI Debates offer a forum for deeper discussion into how major political decisions and security challenges affect markets, investment, and economic growth across the globe.
