Investors still need to tread carefully in emerging markets
The writer is President of Queen’s College, Cambridge and Chancellor of Allianz and Gramercy
After a striking price drop in the first half of the year and a bit of a bounce in recent weeks, more analysts are recommending an increase in overall exposure to emerging market assets.
After all, rating scales for these markets are at historically cheap levels if you look at indicators, both on a standalone basis and relative to developed markets. The bulls argue that with most disruptive forces now in the rearview mirror, a period of lower volatility and higher returns is right ahead of us.
In my view, cheap historical pricing is a necessary but not sufficient condition for a profitable investment in emerging markets, especially for those who have little appetite for volatility.
Investors need to take into account both the dispersal of returns within the asset class and economic and financial impacts that are not yet fully operational, such as rising global inflation forcing major central banks to tighten policies aggressively in a rapidly slowing global economy. Some securities face significant restructuring risk (ie, a price decline that cannot be recovered over time).
The strong overall case for exposure to emerging markets requires significant macro-threats, or what economists call global co-factors, either to raise valuations or be better reflected in valuations.
Remember that this is a challenging operating environment for emerging economies, particularly commodity importers. The growing food and energy insecurity situation is exacerbated by slowing global demand, the appreciation of the dollar, tightening financial conditions for capital markets, and the tighter landscape of bilateral official aid.
Some have argued that this was already reflected in the high volatility and negative returns of the first half of this year. But this assumes, from here, that four factors will not be problematic.
Specifically: that systemically important central banks, led by the Federal Reserve and the European Central Bank, would be able to fight inflation without pushing their economies into recession; that inflation itself will not prove viscous; that more “tourist investors” who ventured far from their natural habitat (and standards) will not escape; And that the internal social and political fabric of countries will be able to absorb a huge blow from the prices of foodstuffs and necessities.
These are not the only assumptions made by those advocating a higher and comprehensive exposure to emerging markets. They also assume that for the more financially fragile economies, official creditors, including the IMF and World Bank, will willingly repeat the disappointments of burden-sharing in 2020.
To help ease the burden of Covid-related emergencies, they have provided significant assistance to emerging countries assuming that private creditors will follow suit. However, the implementation of the debt service suspension initiative and the formulation of the Common Debt Remediation Framework by the G-20 have not been matched by similar efforts from private sources. If official creditors withdraw, the lack of assistance and debt relief would increase the likelihood of painful cuts to social sectors spending, exacerbate climate change mitigation headwinds, increase inequality, and damage actual and potential growth.
This does not mean that there are no attractive opportunities for emerging markets. But rather than investing publicly by tracking indexes or putting money into ETFs, investors should focus on selective opportunities with collateral—whether assets pledged to creditors or implied in the form of very large cash cushions or, in the case of governments, reserves great international.
Investors should seek out the good names that have been hit by the technical contagion of typical emerging markets, distressed assets where payback values are high and those tainted by the failure of local financial markets.
The realities of economic management also emphasize the need for investors to be aware of the potential sequence of events in emerging markets. In the face of rising import prices, falling demand for exports and declining international reserves, countries tend to opt for currency devaluation to aid fiscal adjustment and economic restructuring. For many of them, this will keep locally denominated securities at a disadvantage compared to those issued in hard currency.
The time will come for a comprehensive exposure to emerging markets. For now, a more eclectic approach is in place, including via private markets. Despite this, investors should be prepared for more bumps in the journey to higher returns.