The Evolution of Emerging Markets

Summary:

  • Emerging market countries, and investors, have broadly benefited from rising global growth and positive demographic trends while embracing financial market and structural reforms.
  • The rise in local currency debt issuance provides investors greater opportunities to diversify and enhance their emerging markets portfolio.
  • Investing in emerging markets debt denominated in hard currency and local currency offers investors the opportunity to generate competitive results within the asset class.
  • We believe emerging market economies present compelling investment opportunities at this juncture. Tame inflation, flexible currencies, and improved governmental institutions have enhanced the sector's ability to withstand external shocks. Over the next 2-3 years, we expect to see increased global macro flexibility for EM countries and a continuation of creditor-friendly reform agendas. Overall, the global economy is in a synchronized cyclical growth phase, creating an attractive environment for EM investors.

The evolution of emerging markets

Emerging markets have undergone a remarkable evolution in recent years as these countries have generally experienced improving economic conditions, along with enhanced stability and favorable policy reforms. Emerging market countries now account for almost 70% of global growth in terms of output and consumption (Exhibit 1). Relative growth contribution has been fueled by shifting demographic trends, with approximately 90% of the world's young population (10-24 years old) now living in emerging markets.

Since the late 1990s, many emerging market countries have focused on building resilient markets to absorb global economic crises more effectively while reducing dependency on developed markets. Exhibit 2 includes examples of policies that have helped transform emerging markets.

Exhibit 1: Emerging market growth outpaces developed markets
Global growth in advanced and emerging economies
Actual and forecasted growth from 1976 - 2021


Source: International Monetary Fund (IMF) World Economic Outlook. April 2017. Weighted averages are calculated using market exchange rates. Colored bars show percentage of contribution to output growth; black squares show percentage of contribution to consumption growth.

Exhibit 2: Notable recent policies in emerging markets

Developments in emerging markets Example
Moving from fixed-peg currency regimes to exchange rate flexibility The Bank of Russia moved to a free-float exchange rate regime from an operational band for the ruble.
Embracing structural reforms Supply-side structural reforms in China to address overcapacity in strategic sectors. Additionally, China has also undertaken financial deleveraging to reduce shadow banking activities.
Establishing independent central banks with inflation-targeting mandates The Reserve Bank of India formally adopted flexible inflation targeting to place price stability (CPI inflation), as the primary objective of monetary policy.
Privatizing key state-owned enterprises Nigeria has attracted the highest share of foreign direct investment (FDI) in Africa. Both energy and telecom sectors have been the largest beneficiary of FDI.

The rise of local currency debt

Policy reforms have provided emerging markets with greater financial flexibility and spurred the growth of local currency denominated debt. As shown in Exhibit 3, since the end of 2002 the total outstanding local currency debt, as measured by the JP Morgan GBI-EM Global Index, has grown larger than that of hard currency debt, as measured by the JP Morgan EMBI Global Index.

The rise in local currency debt issuance benefits investors as the expanded bond universe provides opportunities to enhance alpha and yield while further diversifying the portfolio.

Exhibit 3: EM local currency debt issuance exceeds hard currency
December 2002 – June 2018


Source: Bloomberg / JP Morgan. Depicts the outstanding par value of JP Morgan EMBI Global Diversified (hard currency debt) and JP Morgan GBI-EM (local currency debt). Reflects data since the inception of the JP Morgan GBI-EM index in December 2002.

Assessing historical performance

While many investors have incorporated emerging market equity in their global portfolios, a dedicated long-term allocation to EM debt may offer distinct advantages. Historically, Emerging Market Debt has offered investors enhanced yield potential and competitive long-term returns relative to sovereign and corporate debt from developed markets. We continue to see ample positive risk premium on an absolute basis and relative to developed markets. Additionally, emerging market debt has generated higher risk-adjusted returns relative to EM equities for the 10-year period ending June 30, 2018. As investors continue to search for enhanced yield opportunities and increased diversification, we believe actively managed exposure to emerging markets debt may help investors achieve their long-term objectives. Refer to Exhibit 4 for the historical emerging market returns over the last 10 years.


Exhibit 4: Relative to EM equities, EM debt has historically delivered higher risk-adjusted returns
Trailing 10 years as of June 30, 2018

  Emerging Markets Debt EM Equity
  EM USD Sovereigns EM USD Corporates EM Local Markets EM Equity
Cumulative Returns (%) 92.15 83.07 28.82 29.26
Annualized Returns (%) 6.75 6.23 2.57 2.6
Max Drawdown (%) -21.8% -24.30% -29.32% -61.42%
Standard Deviation (%) 8.89 8.56 13.26 22.08
Sharpe Ratio 0.7 0.67 0.16 0.09

Source: JP Morgan and MSCI. EMD USD Sovereigns reflects the JP Morgan EMBI Global Diversified Index. EMD USD Corporates reflects the JP Morgan CEMBI Broad Diversified index. EM Local Markets represents the JP Morgan GBI Global Diversified index. EM Equity represents the MSCI Emerging Markets Equity index.

As the investment universe for emerging markets debt expands, investors have increased opportunities to diversify their exposure across hard and local currency securities. Given the differing attributes of hard and local currency debt, the risk/return profile for the sub-classes can diverge in various market environments. For example, local currency debt typically offers enhanced returns during periods of a weakening US dollar while hard currency debt has historically held up well following periods of rising US interest rates. As such, we believe a blended approach to investing in emerging markets debt may offer investors the opportunity to generate competitive results.

Furthermore, over the last 10 years, emerging markets debt has generally provided higher yields relative to US core bonds. Notably, the yield per unit of duration for emerging markets hard and local markets bonds has outpaced core bonds, as represented by the Bloomberg Barclays US Aggregate Index, over the last ten years (Exhibit 5).

Exhibit 5: On average, EM debt has historically provided higher yields relative to core US bonds
Yield-to-Duration - 10-year average as of June 30, 2018

Source: JP Morgan and Bloomberg. EMD USD Sovereigns reflects the JP Morgan EMBI Global Diversified Index. EMD USD Corporates reflects the JP Morgan CEMBI Broad Diversified index. EM Local Markets represents the JP Morgan GBI Global Diversified index. Core Bonds reflects the Bloomberg Barclays US Aggregate index.

Compelling long-term opportunities in emerging markets
We believe emerging market economies present compelling investment opportunities at this juncture. Tame inflation, flexible currencies, and improved governmental institutions have enhanced the sector's ability to withstand external shocks. Over the next 2-3 years, we expect to see increased global macro flexibility for EM countries and a continuation of creditor-friendly reform agendas. Overall, the global economy is in a synchronized cyclical growth phase, creating an attractive environment for EM investors. Given our view that EM countries are structurally different than 15-20 years ago when the Federal Reserve last embarked on a sustained hiking trend, we think the sector is likely to generate competitive performance in the current environment.

In spite of the slowly falling GDP growth rates over the last 15-20 years, we believe emerging markets will continue to generate higher GDP relative to developed markets in the years to come. Comparatively lower debt loads and high FX reserves suggest EM economies have the resiliency to continue to outperform their developed market peers.

To meet the demands of a growing population with aims to developed world infrastructure standards, we believe emerging market countries and companies will pursue sensible debt financed development. In addition, we think debt issuance to fund projects such as infrastructure, ports, or health care are likely to continue to offer investors a favorable opportunity set.

While the emerging market debt universe continues to grow, it is important to note that not all emerging market economies are created equal, investors must carefully discern country, credit, sector and currency risks. As a result, we believe it's prudent to use a disciplined process that relies on unbiased fundamental research to actively manage portfolio risk exposures.

Overall, emerging markets have witnessed a tremendous transformation over the last decade and are now a driving force behind future global growth. As investors continue to search for enhanced investment opportunities and increased diversification, we believe actively managed exposure to emerging markets debt can potentially help investors achieve their long-term objectives.
 

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