How have emerging markets (or, EM) changed over the years, and are they better equipped to handle volatility?
We asked Sun Life Global Investments’ portfolio manager Christine Tan to share her observations about the changing role of emerging markets in the global economy, and the implications for those saving and investing for retirement.
- How have emerging markets transformed structurally to better handle market shocks and volatility over the years?
We have seen emerging markets change dramatically over the last 15 years. These changes have made EMs somewhat more resilient to global macro risk and global market shocks. They are still not immune, but they have substantially improved.
Today, most EM governments are more responsive to the needs of the people. And if they are not implementing the right reforms and policies, they are being voted out. This lays the groundwork for more sustainable growth and development.
Emerging market central banks are much more orthodox today where they approach monetary policy with the dual mandate that we are familiar with in developed economies, namely inflation and employment. They also provide transparency and communicate their target inflation and policy approach. This provides an improved understanding of the interest rate outlook.
Another factor is foreign exchange reserves. In 1995, EM held about one-third of the world’s global foreign exchange reserves. Today, they hold about two-thirds, led by China, but also countries like India, Brazil and Russia, giving them the flexibility to intervene to stabilize their currency if necessary. It also enables them to repay any debt they might have in U.S. dollars. Several EM countries issue bonds in U.S. currency because the interest rates are lower and it provides them access to global bond investors.
The last factor in resiliency is domestic consumption. Many EM countries now have a base level of income that is high enough to support stronger domestic consumption. Looking at the global financial crisis of 2008, many EM countries were able to hold their own – partly due to these domestic drivers, but also due to their government’s economic stimulus – returning to the point about governments being more responsive.
These are only some of the key factors that have transformed emerging markets and made them more resilient to global macro shocks today. Emerging markets today are now home to half of the world’s consumers and 90% of the world’s population below age 30. This will be an important driver of global growth for years, if not decades.
- A decade ago, retirement savers might have avoided emerging markets. Why do you think EMs could have a place in retirement portfolios?
First, the asset class has changed. Fifteen years ago, it was smaller and less diversified. China played a bigger role and many of the other economies were relatively small. Today, almost 50% of EMs’ economic growth comes from China, but you have India representing about 18%, and the other EM economies also contributing.
This diverse group of countries have different economic drivers and varying business cycles, which means the overall asset class has declined in volatility, which has improved the risk-reward potential.
For investors, yields (dividend and bond) remain quite low in developed markets such as Canada and the U.S. because of low central bank rates and quantitative easing. So, diversification into EM fixed income should be on the radar for investors who are seeking higher yield alternatives.
Lastly, large institutional investors – who we call “smart money” – are allocating to EM. Canadian investors are all likely familiar with the Canada Pension Plan (CPP). The CPP already has a 16% allocation to EM. The new head of the CPP Investment Board (CPPIB) announced recently that by 2025, the intention is to double that EM allocation to about 33%.1
In addition to the CPPIB, numerous pension funds and sovereign wealth funds worldwide are also increasing allocations to EM.
We refer to this group as “smart, sticky money” because these institutions are large and invest with a long-term time horizon rather than making short-term allocations.
- Today there are more emerging markets asset classes available than just equities. As a portfolio manager, can you describe how things have changed?
EM is no longer simply about equities, which is probably the asset class with which investors are most familiar. There is also fixed income, and within that are government bonds (most of which are investment-grade rated) and corporate bonds.
An interesting aspect of EM bonds is that asset class’s low correlation with Canadian and U.S. bonds, making it a useful diversifier for many fixed-income investors. This is in addition to yields historically being higher for EM bonds, partly because these countries are growing faster and in a higher inflation-risk environment. EM interest rates are similar to where Canada’s were in the 1980s and early 90s.
The EM equity universe has also matured and evolved. Often, investors think of resources and manufacturing when they think of EM – the more cyclical sectors. However, the sector that has grown the most and has the largest index weight now is technology.
Today, EM is home to several of the world’s largest mega-cap technology companies, such as Alibaba, the Amazon of China. Moreover, two big tech consulting firms that have become global brands – Cognizant and Infosys – are both domiciled in India. These types of companies make up a large part of the current EM equity index.
Financials as well as consumer discretionary and consumer staples are also large sectors, reflecting the rapid growth in domestic consumption. We believe this sector diversification, with a market less focused on cyclical industries, strengthens the investment case.
The basic EM investment thesis is that these countries are starting from a lower base income and a lower urbanization rate. This means there is greater opportunity for growth with economic and social change. For example, market penetration of many basic goods, such as cars and refrigerators, is very low; home ownership and even credit card penetration are in their infancy, so there is room for domestic consumption growth. In developed economies, these opportunities are considered mature, whereas they are still in their early growth phase in EM.
- In your experience speaking with advisors, what range of allocations to EM have you observed in their clients’ portfolios?
As a portfolio manager, I have spoken to financial advisors across Canada about emerging markets and I have noticed that the allocation to both EM equities and fixed income varies significantly depending on the client base and the way they approach asset allocation. Generally, I’ve noticed that the allocation has been gradually increasing. The EM equity allocations I have seen could be up to 10 to 15 percent of an equity portfolio. Meanwhile, the EM fixed-income allocation could be up to 20 percent of a fixed-income portfolio, especially when advisors start looking for alternatives to some of their high-yield bond funds.
Advisors seeking alternatives now tend to think that EM fixed income is interesting because it currently offers similar yields to high-yield corporate bonds in the U.S. and Canada but with many of the issuers being investment grade. As financial advisors and their clients become more comfortable with these asset classes, we could see more advisors recommending EM for their clients’ portfolios.
- As with many investment categories, there are index alternatives for EM investments. Why do you think active management is important here?
There are numerous index alternatives, whether country-specific ETFs or the broad EM index. We believe active management is crucial because EM still has many inefficiencies in terms of the index construction, the dissemination of information and the assessment of the qualitative aspects of a company.
These economies are growing quickly, and while finding growth opportunities is not difficult per se, the focus is on identifying businesses with a competitive moat and experienced management teams that are equipped to handle the economic cycle. The challenge is also to find management that allocates capital effectively. When investing in a product that tracks an equity index, you are buying the strong management teams as well as the mediocre management teams.
Index construction, I believe, is even less efficient in EM than it is in the developed world. For example, in Russia or the Philippines, the index comprises several mega-cap companies, often with low allocation to some of the newer industries, especially technology. Some of the faster-growing industries are not being captured. More important, you might end up investing in some of the very large, slow-growing, state-owned companies that typically dominate indexes.
Being an active manager is extremely important from a selection perspective. The main EM index gives you exposure to only about 1,150 companies, while the broader listed investible EM universe exceeds 20,000 companies.
The important aspect of active management in my view is risk management. When the markets rally, global growth is strong and risk appetite increases. Investing in EM through index funds may appear more attractive since fees are lower. However, when the markets are more volatile and when the macro environment is in flux, risk management becomes more important.
In addition to stock selection, an active manager can make decisions about country allocation. For example, if oil prices were high, certain countries such as Russia and Brazil benefit. The oil-importing countries, on the other hand, may have a tougher time as they would pay more for oil. The converse is also true: if oil prices correct, as they did in 2015, the countries that import oil would suddenly do better. These all represent active “calls” that an active manager makes, and that an investor investing in a broader index would not be in a position to do.
Ultimately, I believe that regardless of what is happening in the markets today, tomorrow or down the road, emerging markets will continue to grow and develop. Investors who want more value for their retirement portfolios should remain open to the potential that EM investments may be able to generate over the long term.
1 Source: Globe and Mail online article, New CPPIB Strategy Focused on Boosting Competitiveness, May 17, 2018.