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Emerging markets –
don’t let them be the one that got away

Our viewpoint

When seeking a long term partner, we all look for many attributes we find attractive: common interests, generosity, sense of humour…and we accept that, being human, they may have some less positive traits that we will find a way to live with. Sometimes they will be a put off, thus ending the whole thing – but there is always the potential of “regret risk”. Could it have worked with that one that got away?

Metaphors can grab attention but they should not be overstretched. So let me say it is no secret that emerging markets (“EM”) offer the potential for greater growth than developed market counterparts. Firstly, their equities have outperformed over long term periods (eg 10 years); secondly, their bonds offer far greater yields than in developed countries (which is especially attractive in today’s “low yield” environment); and thirdly, we may expect their currencies to strengthen as they evolve from economies based on exports to being hungry for imports. 

So do EM have potential as an attractive long-term partner for investors? 

Investors seem to be resisting their charms. Allocations I see to emerging markets for typical UK pension funds are surprisingly low – perhaps it is the perception of risk which is putting investors off?

I’m not suggesting that emerging market investing is plain sailing; the risks are real and must be understood and considered carefully. But I believe perception has moved away from reality and, so if you have avoided EM and you have a reasonable investment time horizon (of say 10 years or more), you may be running the risk of looking back and seeing emerging markets as the “one that got away”. So what’s been putting you off?

Trumped?

Let us extend our metaphor…how many times has a potential relationship failed before it actually began because there was another suitor lurking in the background threatening to steal your partner away, or turn them against you?

I imagine in this situation, you would want to think carefully about how real the threat was and the impact they might have. So when Donald Trump uses language that could result in policies that hurt EM, it’s worth a detailed look at the damage he could actually cause.

During his campaign, Trump was very clear on the fact that he would re-write trade agreements to the benefit of the US. This is particularly threatening for emerging markets as, for many, the US was their biggest trading partner.

Initially, Trump appeared to be following through with this policy. However, a few months in to his Presidency the talk is now of preparing orders to “review existing trade deals” or to “study abuse of US trade deals” so perhaps a measured approach will be taken as commentators question whether trade tariffs and relocation of labour will be good for the US at all?  So those investing in EM may have less to worry about than first thought?

The mighty $?

A strong US dollar is usually seen as bad for emerging markets: many EM economies have issued a large proportion of their national and corporate debt in US$ terms, so a more expensive dollar means it is relatively more expensive to service this debt. 

On news that Trump had been elected, the dollar immediately strengthened and there were thoughts that this may continue throughout his Presidency, but things haven’t been as clear cut since – the dollar has weakened overall this year; so emerging markets haven’t actually seen a bigger bill for their debt at all.  These markets are also a lot less exposed to the dollar than they have been in recent years – the scare caused by the “taper tantrum” in 2012 led many EM countries to reduce the level of their debt and the proportion that was linked to the dollar. 

A feisty temperament can be hard to handle

I’m sure you can see the analogy here: emerging markets are more volatile than their developed market counterparts, and I’ve often been told it’s this that puts investors off.  I would urge you to think about your investment horizon: if you have 10 years of equity investing left (or more), you might be able to afford to keep your patience through short term temper tantrums, in order to achieve the long term benefit of greater growth.

There are also approaches you can take to avoid falling out with these investments:

  • An active manager may be able to avoid the most temperamental companies or countries at any given time, re-positioning the portfolio when things change. Just make sure you have conviction in your manager.
  • A multi-asset approach (seeking to make returns from EM equities, bonds and currencies) is an effective way of gaining exposure to these high-growth markets whilst diversifying risks and hence dampening the level of volatility.

Are they really worth it?

You should at least ask the questions and kick the tyres. Ask your investment consultant the following questions at your next trustee meeting:

  • How much exposure do we have to EM assets?
  • What are the potential risks and rewards from EM equities, bonds and currencies? Are these risks worth taking?
  • And if you do consider increasing your allocation then investigate implementation routes that might dampen volatility along the way.
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