Emerging markets: Out of adversity comes opportunity

Fast-forward to the summer of 2015 and sentiment towards the asset class has shifted markedly, following three years of weak performance and depreciating currencies.

Two main factors must take the blame. First, the Chinese economic powerhouse is stalling. 

Rapid growth in property development over the last decade resulted in a build-up in unsold housing inventory and unsustainably high levels of construction activity, ultimately putting pressure on the commodity markets and those exporting to China.

It also resulted in a slowdown of economic growth in China itself and raised concerns about the accumulation of bad loans in the financial system.

The second major factor is that emerging markets remain vulnerable to the ebb and flow of global liquidity which, in the era of quantitative easing and near-zero interest rates in the developed world, has proved all the more dramatic.

Economic necessity has driven positive political outcomes in Mexico and India, where parties that promised wide-reaching economic reforms won the elections

QE drove down the return investors could obtain from assets such as US government bonds. Consequently, some sought more profitable opportunities elsewhere, including in emerging market bonds.

This has left emerging markets vulnerable to the eventual tightening of monetary policy in the US. As a result, we have seen a painful two years in preparation for this.

On the bright side

The good news is that for many emerging markets, much of the necessary rebalancing has already taken place.

With the exception of some economies that export construction-related commodities to China, emerging market countries have generally seen a gradual improvement in current account positions, decreasing their dependence on foreign capital flow.

Real rates – the returns earned by investors in emerging market bonds in real terms – are now firmly in positive territory, which should make these investments more attractive and help the region to withstand higher interest rates in the US.

However, the asset class is anything but homogeneous. Now more than ever it pays to differentiate between those countries that have made the most progress in tackling economic imbalances and setting themselves up for stronger and more sustainable growth in the future, and those where there is more to do.

Economic necessity has driven positive political outcomes in Mexico and India, where parties that promised wide-reaching economic reforms won the elections.

Implementation of the reform agenda should shift the economic growth trajectory to a higher level in both countries.

In China there are positive signs of implementation of reform measures. In particular, reform of the state-owned enterprise sector is under way and a shift towards environmentally friendly technologies is becoming more pronounced. 

However, the scale of the task facing the authorities to rein in the reliance on debt creation for economic growth and to offset the impact of the slowing construction sector remains a concern.

Importantly, investors should not lose sight of the structural growth drivers that have long made emerging markets an attractive area for investment, as these remain as compelling as ever.

At the centre of these is the rapidly expanding middle class, eager to enjoy a higher standard of living and consume a wider range of goods and services.

The opportunity for active investors to seek out higher returns looks better than ever.

This is why the focus should be on those markets where progress has been greatest and on companies that are best positioned to benefit from these reforms.

For active investors, emerging markets remain rich with opportunity. 

Irina Miklavchich is head of emerging market equities at Columbia Threadneedle Investments