The market environment for emerging markets has changed significantly in recent years. Slowing global growth and tightening financial conditions have created a more challenging environment. For some, this only reinforces the perception of emerging markets as a purely short-term, tactical allocation that, while potentially offering high returns, comes with increased risk and volatility. However, this traditional way of thinking no longer does justice to today’s emerging markets and highlights the need for a more nuanced investment approach. While the global environment has become more difficult, it also highlights the differentiated nature of emerging markets, as fundamentally well-anchored countries differentiate themselves from weaker counterparts.
Rising interest rates have cut off some emerging markets from the capital market
The guide to investing in emerging markets has changed as decisions no longer depend primarily on the stage of the global economic cycle. While an expanding global economy, high raw material prices and moderate monetary policy conditions were previously considered prerequisites, many emerging countries are far less dependent on external factors due to their increasingly domestic economic orientation. While these are still influential, they are part of a broader mosaic alongside the fundamental influences at country, sector and stock levels. Today’s emerging market landscape therefore requires a more detailed approach and country-specific expertise as broad generalizations become increasingly vulnerable. In addition to the differences between individual countries, emerging markets offer a diverse range of assets to invest in, including hard currency government and corporate bonds and local currency bonds, as well as deeper, more mature equity markets.
The external environment has also changed significantly in recent years and the steep rise in interest rates in developed countries, particularly the US, is expected to last longer than initially expected. The impact of these restrictive policies is felt disproportionately in emerging market debt markets. On the one hand, there is a group of countries, including Mexico and the larger economies of South America (e.g. Brazil, Chile, Peru, Colombia), that can rely on robust fundamentals. This group continues to have access to credit markets and spreads have remained reasonable and relatively stable. On the other hand, there are a number of fundamentally weaker emerging markets that are, as a result, increasingly cut off from credit markets. In the decade before the coronavirus pandemic, when global interest rates were near zero, many emerging markets were able to access international capital markets for the first time and issue new bonds at manageable yields and with relatively low risk of default. However, today, with key interest rates close to 5.5%, these countries are simply no longer able to issue new bonds at sustainable yields. Lacking access to the market, they are struggling to refinance their debts that are nearing maturity, and many of them have either already defaulted or are at risk of doing so.
Opportunities in the manufacturing sector
One of the biggest misconceptions among investors is that emerging markets are home to only dynamic, growth-oriented companies, while more defensive, value-oriented opportunities are few and far between. Data shows that the majority of all active funds flowing into emerging market equities are invested in growth/core strategies, while only a fraction of the total funds flow into value strategies. This huge distortion means that many value-based opportunities, particularly in traditional “old economy” sectors such as manufacturing, are overlooked or ignored. As a result, there are many good companies flying under the radar at potentially very low prices.
The current environment of heightened global uncertainty only makes these value-oriented companies more attractive, as growth-oriented assets are sensitive to higher interest rates. Companies with a relatively low risk profile, reasonable price-to-earnings ratios and predictable return streams may not fit the traditional notion of “dynamic” emerging market investing, but they do exist. The beauty of these long-lasting companies is that they can generate significant returns over time. They are unlikely to be among the best emerging market performers in a year, but when you look back over a 5 or 10 year period, particularly where market uncertainty/volatility has been a feature, the value creation becomes clear.
Governance structures have improved
Significant reform measures have been implemented in many emerging markets, meaning that most are no longer just a few bad decisions away from a crisis. Detailed research is crucial to identify the countries that are truly committed to consistent, market-friendly policies and to avoid those that are moving in the wrong direction. On the corporate side, great progress has also been made in improving corporate governance and a greater focus on shareholders. While complicated governance structures, immature institutions and untrained management once characterized the corporate landscape in emerging markets, these characteristics are now the exception rather than the rule. Even if they occur in emerging debt markets, there is no longer any fear that these events pose a systemic risk to the entire asset class. Over the last 25 years, such periods have proven to be relatively short-lived, providing opportunities to enter the market at potentially very low valuation levels.
Emerging market domestic trade exceeds trade with developed countries
The growth of emerging market debt as an asset class in recent years means that investors have access to a much broader and more diverse range of credit options, spanning countries, financial and non-financial sector issuers and the entire ratings spectrum. While it is recognized that market uncertainty and the mixed global economic outlook are important influences on the overall outlook for emerging markets, these must be balanced against the strengths of individual national economies and the positive long-term trends that underpin them continue to support long-term optimism in emerging markets in general.
An example: Many emerging countries continue to record positive economic growth at rates
far ahead of those in developed markets. This is a sign of emerging economies that are less dependent on developed countries to thrive. Domestic trade between emerging economies has now exceeded foreign trade volumes with developed countries, while a growing middle class in emerging economies is supporting long-term domestic demand. The emerging countries still have a lot of scope to improve their productivity and catch up with the industrialized countries. Large, young and increasingly educated workforces, together with the increasing penetration of technologies, are central to closing this gap. However, exploiting this potential is becoming increasingly nuanced, and it is more important than ever to have a good sense of which countries are successful and which are at risk of stagnating.
China remains the ESG driving force of emerging markets
Sustainable bond issuance in emerging markets has increased significantly in recent years, driven by robust issuance activity from some relatively new entrants, including the Philippines, Mexico, Colombia and Chile. This complements prominent issuance in more mature markets such as China. Although emerging economies still lag far behind the emissions of advanced economies, this trend is expected to continue as emerging economies increasingly seek to finance their sustainable development goals. Also worth highlighting are the huge investments China has made in recent years in switching from fossil fuels to cleaner energy sources. China is now the world’s largest producer of wind and solar energy and also the largest domestic and foreign investor in renewable energy. This shift will bring benefits to emerging market countries and the companies adapting to this transition, and will have a positive impact on energy security and affordability across the region.
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Photo: Chris Kushlis © T. Rowe Price