Emerging markets are an increasingly important part of the global financial markets and have progressed considerably over the past 20 years. Traditionally thought of as developing countries in which investment would be expected to deliver higher returns, albeit with higher risk than investments in developed countries, what factors should be considered before actually investing? And does the recent volatility in these markets present an investment opportunity, or should investors maintain a degree of caution?
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When investing in emerging markets, there are a variety of additional factors that investors should consider over and above those typically considered when investing in developed markets. The greater perceived risk typically stems from the poorer governance structures and generally lower level of regulation, in combination with an informational gap created by all manner of factors, including but not restricted to, different accounting standards, languages etc. Luckily for the investor there are many excellent managers to do this ‘heavy lifting’ of further analysis but there are still some important considerations to take into account.
To illustrate the rising importance of emerging markets, Figures 1 and 2 show the increasingly large market capitalisations of the bond and equity markets, respectively. Figure 1 shows the rising amount of debt issued by emerging markets both in US dollars and also in their local currency. Traditionally, emerging markets were characterised by lower liquidity and an emphasis on issuance of US dollar denominated debt. Greater debt issuance has resulted in deeper and more liquid markets which makes investment easier.
The traditional sin of emerging markets only issuing in US dollars has also been mitigated to a degree by the fact that emerging markets economies increasingly issue debt denominated in their own currency (both sovereign and corporate debts). Having evolved their economies through improved fiscal and monetary policy, governments have also been able to term out the maturities of their debt issuance as well. Both of these factors help improve the overall stability of the economy in question, not least because large imbalances in terms of currency between the country’s assets (tax revenues) and its liabilities (government debt) do not exist, and there is less dependence on short-term financing which is subject to the fickle nature of investors’ confidence, or lack thereof. Thus, whilst the resulting ride in emerging markets may not be smooth, these economies are in a much better shape than previous decades, and a full blown emerging market crisis seems less likely as a result.
The importance of currency
Clearly, the currency of issuance in emerging markets government debt is therefore important. To illustrate this point Figure 3 shows returns of both hard and local currencies, and hedged and unhedged returns year to date. The difference between the hard currency benchmarks in terms of hedged and unhedged is small, reflecting the fact that the vast majority of hard currency debt is denominated in US dollars (although the euro is becoming an increasingly popular choice). However, the difference between hard currency and local currency is marked. The combination of market volatility emanating from China, a weak commodities complex and the prospect of the Federal Reserve raising interest rates has created a perfect storm with the result that emerging markets currencies have sold off to record lows.
So, getting the call wrong about currency in emerging debt markets can be a painful experience. A rational investor would almost certainly consider ensuring that they have the ability to hedge the currency exposure, and whilst not necessarily always cheap, it is a wise approach in the current volatile markets. This is illustrated by the local currency government debt hedged into US dollars in Figure 3 which shows returns in line with hard currency debt.
If currency is an important consideration in the debt markets, does this principle also hold true in the equity markets? As already shown in Figure 2, emerging equity markets have increasingly become a larger and more important component of the global equity markets. The answer here is that currency is a less important factor owing to the higher expected returns of equity, thus the opportunity cost of ‘getting it wrong’ is less, in conjunction with the fact that equity market volatility is much higher than debt market volatility, which masks the effect of any currency moves.
Probably a more important consideration in emerging equity markets is their greater exposure to commodities, and whilst they have benefited enormously from the super-cycle over the past few years, the commodities complex is under significant pressure currently as evidenced by falling prices virtually across the spectrum. Here, the investor would want to focus on companies which are not commodity-related and which have a strong track record in generating free cash flow and are thus defensive in nature, and so will be better insulated against ongoing market volatility.
In conclusion, emerging markets have become a more important part of the global financial markets. Whilst the outlook for emerging markets is not clear, it appears that a full blown crisis is unlikely at the current time. Currency is an important consideration, especially when investing in the debt markets (for both government and corporate debt).