By the start of 2015, emerging-markets equities had significantly underperformed developed-markets equities for the past few years. More than two months into this year, though, the performance of emerging and developed markets have been more or less in line. It is premature, however, to hail the renaissance of a recovery in emerging-markets relative performance, even as the strong U.S. dollar is having a negative effect on the forward earnings estimates of U.S. companies while also having a positive effect in most emerging markets. Lower oil prices are on track to deliver a noteworthy economic benefit to emerging markets, in Asia in particular, providing another potential tailwind to performance.
Against this backdrop, how are institutional investors perceiving their allocations to emerging-markets equities and bonds?
The main reasons that institutional investors allocate to emerging markets include a desire to access the broader growth story, the aim for potential additional returns and the perceived potential diversification benefits. In the U.K., for example, most pension funds have considerably more exposure to emerging markets than a decade or more ago. In our view, this results from both increased allocations to emerging-markets-specific mandates — across equities, bonds and multiasset-class investments — and the impact of a greater presence of emerging markets within capital markets for global mandates, such as global equities.
In our experience, pension funds of all sizes are tapping into emerging markets through a variety of methods. Smaller schemes are opting for multiasset vehicles, such as specialized emerging-markets multiasset strategies and broader diversified growth strategies that selectively invest in emerging markets. Larger schemes tend to achieve specialist exposure through emerging-markets equities allocations, through emerging-markets debt allocations or a combination of both.
Recent periods of volatility and subsequent negative returns have led some investors to question whether the original attractions for investing in emerging markets remain valid. Other schemes have mitigated the effects of the present tricky investment environment through actively managed allocations, appropriate diversification and by spreading an investment over a period of time to average in the price of investment.
Looking ahead, divergent outcomes should be expected from emerging markets this year. A selective approach is more important than ever. The divergence will come from the actions of developed-markets economies, rather than necessarily the emerging markets themselves. At the same time that the Federal Reserve is looking toward tightening monetary policy, the European Central Bank and the Bank of Japan remain highly accommodative and have scope to provide additional monetary stimulus measures. The consequences and interactions of these decisions will leave certain economies better off than others.
Overall, in our view at Investec, the cyclical environment remains somewhat supportive for emerging-markets equities outside of oil-producing economies, and valuations still look appealing relative to history and to developed-markets equities. Corporate discipline is improving, and reform continues to progress, across many of the larger economies. These are reasons to remain positive over the medium term, despite near-term volatility.
Across asset classes, emerging-markets equities appear more compelling than emerging-markets debt, although this bias has weakened somewhat. The risk premium offered by local currency emerging-markets bonds is attractive, especially as lower global energy costs have substantially improved inflation outlooks across developing economies.
The significance of emerging markets to the global economy and the global financial system has never been greater, with China now the second-largest economy in the world and Brazil and India in the top ten. Also, whereas financial assets for emerging markets have historically been significantly underrepresented, we are seeing an evolution, with government-bond, corporate-bond and public and private equity markets coming to the fore. For those navigating the road ahead, it is more important than ever to be selective.
Michael Spinks is co-head of multiasset, and Atul Shinh is an investment specialist, both with the multiasset team at Investec Asset Management in London.
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