Capital Group's Richard Carlyle looks to next chapter in emerging markets
As growth differentials between emerging markets (EM) and developed markets (DM) have narrowed, and EM equities and bonds continue to lag those in DMs, some investors are now questioning whether the EM story still makes sense. Despite EM investment returns having become increasingly challenged, at Capital Group we believe that the traditional case for emerging market investing has been all about growth, and that case still holds strong.
Looking at recent market performance, it has been driven primarily by the narrowing economic growth differential between emerging and developed markets. EMs were growing more than 6 percentage points faster than members of the OECD in 2009, but the margin has now narrowed. While economic growth does not always drive capital markets, improving activity is often a catalyst for rising revenues and earnings. The opposite is, however, often the case and as GDP growth has slowed, corporate earnings expectations in emerging markets have somewhat moderated.
Despite this backdrop, I believe that the long-term structural factors that drive EM growth are still very much intact. While growth forecasts for EMs have moderated, EM growth is still anticipated to exceed that in developed markets. Evidence for this can be found in the IMF’s October 2014 forecast[1], suggesting that although EM growth may slip to 4.7% this year, it is likely to pick up slightly to 5% in 2015. That compares sharply with just 1.8% growth anticipated for advanced economies in 2014.
Furthermore, I see the size of emerging markets also pointing to greater potential. Currently, companies listed in emerging markets constitute only 18% of the market capitalisation of the MSCI All Country World, despite emerging markets representing 83% of the world’s population and generating 39% of global GDP. Such demographics are, therefore, also encouraging as the working-age population is expected to increase in most EM countries by 2020, in sharp contrast to the more challenged demographics of many DM countries. When this is combined with rising living standards, increased per capita GDP, a growing middle class and increased discretionary spending, the EM investment story still remains compelling.
Besides the well-known cases for emerging markets, I see other new factors evolving that are also contributing positively to the EM investment case. Importantly, countries’ and companies’ access to capital has improved in emerging markets. In 2014, Chinese companies have been leading equity issuers[2], frontier countries like Senegal and Ghana have brought debt issues to market and financial markets have continued to evolve through improved liquidity as more institutional investors begin to participate.
Furthermore, the changing role of China is increasingly impacting EMs as the country’s continued development paves the way for it to assume a global leadership role. Indeed, whilst China recently overtook the US as the largest economy[3], it also stands to benefit from strong entrepreneurialism, technological advances, currency convertibility, and a shift from a low cost manufacturer to a centre of excellence across several sectors, such as telecoms and IT.
The strength of the long-term and evolving factors therefore continue to present a compelling story, leading many to question ‘When is the right time to invest in EM?’. For long-term investors, attractive valuations can be an appropriate entry point to emerging markets and currently many EM stocks are trading at discounts relative to historical averages and developed market peers. However, emerging markets have historically been volatile asset classes, and most investors need not be reminded how volatility, particularly large drawdowns, can dampen long-term returns significantly. In addition, you must bear in mind that results within and across the EM debt and equity universe often vary significantly from year-to-year.
Given this, I believe it is important to take an active approach in order to take advantage of the differentiation opening up in emerging markets, but also to manage the volatility inherent in emerging market investing. In particular, at Capital Group we believe that broadening the investment universe to look across all asset classes in emerging markets can be a powerful way of approaching emerging marketing investing and, therefore, in effect giving yourself the maximum possible number of tools to manage risk and return.
Therefore, although the long term case for EM investing remains intact, near-term headwinds suggest that a greater focus on managing volatility, and an active approach to capturing the opportunities offered by increasing differentiation, will prove critical to the EM investment story as we move into the next chapter.
[1] Overview of the world economic outlook projections. International Monetary Fund. October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/c1.pdf
[2] Dealogic. ECM StatShot. 19.09.2014
[3] International Monetary Fund. October 2014
Richard Carlyle is investment specialist at Capital Group
