A glass half full: How investor sentiment towards EMD is changing
EMD survey: A higher birth rate and a growing middle class eager to spend money on goods and services are often touted benefits of investment in emerging markets, but something else is driving flows as well.
The potentially high rewards are balanced by specific risks: local currencies can be volatile, and political change abrupt and sometimes directed against free markets.
The case for investing in emerging countries has always depended on investors’ macro views, as well as their risk appetite, but low growth and low yields in the developed world have pushed many to look to new places for returns.
There is a general feeling that EMD is back on the table
Emerging markets are experiencing a big comeback among institutional investors: for example, in July, the largest flow volumes in exchange-traded products were into both emerging market equities ($8.2bn, £6.3bn) and emerging market debt ($3.9bn, £3bn), according to asset manager BlackRock.
The Institute of International Finance association says $10.2bn of assets flowed to emerging markets in July.
Concerns take a back seat
Performance of EMD disappointed not that long ago, and the tapering that followed quantitative easing meant investors expected yields in developed markets to pick up.
The movement towards EMD is more a push than a pull, however. While performance has been strong, it is mainly the cold yield climate at home driving EMD flows to new shores as the UK is experiencing the lowest interest rates in centuries.
The latest moves by central banks have pushed UK asset owners away from home turf with renewed vigour.
Strathclyde Pension Fund is one of the more high-profile movers in the asset class, having issued a tender for up to £250m in early August for mandates “including local and hard currency sovereigns and corporates… to achieve meaningful returns above a blended benchmark return”, the fund said in its official tender notice.
The Strathclyde scheme is advised for its search by consultancy Hymans Robertson. Research consultant Allison Galbraith says EMD is being looked at more favourably again, but not because of the sudden occurrence of positive factors helping those markets.
Fundamentals have not improved enough to justify the fact that local currency is up about 14 per cent and hard currency about 10 per cent this year. The reason for the pick-up in investor activity is simply that yields in developed markets have declined again.
And while the risks generally associated with the asset class – such as currency fluctuations, political instability, increased likelihood of bankruptcy – have not gone away, they are perhaps not at the forefront of investors’ minds at the moment.
EMD is one of many for investors
Andrew Cheeseman, chair of professional trustee company Pan Group, agrees that investors are looking at the asset class once more. “There is a general [feeling] that EMD is back on the table,” he says.
Most pension funds pulled out of EMD about two years ago, when performance went down, he says, but adds that “the writing was on the wall three years ago”.
Cheeseman blames consultants for the fact that schemes did not move assets out earlier: “Consultants were slow to advise their funds.”
While the asset class is now once again on the agenda, talks about allocating money are at an early stage.
“The discussions between trustees and managers are probably still in their embryo days,” he says.
Cheeseman also points out that EMD is by no means the only potential new investment on schemes’ radar as they prepare to venture into higher return territory.
“They’re also looking at other things, there’s not a flight to EMD,” he stresses.
Is this time different?
Simon Lue-Fong, head of global emerging market bonds at Pictet Asset Management, says as returns became positive, especially for local markets, people started to feel much more comfortable about the trajectory of emerging markets. “It’s a case of glass half full or half empty,” he says.
But this new attitude hides underlying problems with the sector. Lue-Fong believes emerging markets might have hit a turning point.
There’s still another generation of outperformance to be obtained
While “the balance sheet of most emerging market countries is still relatively good, it is deteriorating in slow motion”, he says.
Growth is important for countries’ balance sheets, but “growth in emerging markets has been lacklustre for a while”, he notes, citing the number of quarters that GDP growth deviates from its potential as an indicator of problems.
When emerging market growth went negative from potential between 1991 and 2012 it usually stayed negative for two to six quarters, according to Lue-Fong.
“What I noticed though since 2012, there have now been 16 consecutive quarters of negative growth deviation from potential,” he says. “This time really is different.”
Liquidity fears
He also cites liquidity as a challenge to the market “for many years to come, and there doesn’t seem to be any solution”.
But Noel Collins, senior fixed income consultant at Mercer, says that in the EMD space, liquidity has reduced less than in other bond markets.
He agrees that for asset managers that are not very active, liquidity is something to bear in mind.
“However, it’s also a market that’s grown over the past few years. The market’s been able to absorb the increased interest,” he notes.
Regarding the growth prospects for emerging economies, Liam Spillane, head of EMD at Aviva Investors, is positive. “We are starting to see a pickup of fundamentals, a widening of the growth differential,” he says.
He notes that the valuation argument is “very compelling across the whole asset class but particularly in local currency EMD”, adding that in his opinion the asset class is “cheap, and is yielding”.
Collins also appears less worried about a narrowing growth differential.
While he concedes that the difference between growth levels in the developed and emerging world has narrowed, he is optimistic that outperformance will continue to be achieved for many years to come.
“There’s still another generation of outperformance to be obtained,” he says.
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