A discerning view on EMD opportunities

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By A Paris  The benefits of diversification have been highlighted in the past 18 months and in this context, institutional investor appetite for emerging markets has increased. As they hunt for returns in a low interest environment and seek to take advantage of dislocations resulting from the Covid-19 turbulence, investors and asset managers have underscored the role an allocation to developing markets can play within portfolios.

Although investment in emerging markets typically represents greater levels of risk, the opportunity identified is currently considered worthwhile, according to managers and institutional investors.

“Conditions for emerging market debt outperformance in 2021 appear to be in place. First, a global backdrop of steady, extended monetary accommodation, prospects of a large-scale deployment of Covid-19 vaccines, and, to a lesser extent, expectations of fiscal stimulus in the US, should boost the growth-sensitive segments of the asset class,” wrote the Morgan Stanley global fixed income team in an outlook briefing. “Therefore, high yield credit, emerging market FX and local currency high-yielders should outperform investment grade, which has less of a valuation cushion, and is vulnerable to potentially steepening yield curves in our opinion.”

Large investors in the space cemented their commitment to emerging markets over the course of the year. In its latest annual report, released in May 2021, The Canada Pension Plan detailed the growth of its investments in emerging markets from USD87.6 billion to USD104.2 billion, representing 21 percent of the fund’s total assets of USD497.1 billion.

“Despite the magnitude and scope of the recent global health crisis and economic shock, other fundamental long-term trends that underpin our investment strategy remain in place. For instance, we still project emerging markets will account for a higher share of total global economic activity over the coming decade, with the share of world GDP accounted for by emerging economies expected to surpass 50 percent during this time,” the fund outlined.

Kevin Sneader, global managing partner, McKinsey gives a cautiously optimist view, underscoring the need for a discerning approach. He wrote in an article: “While it would be rash to assume that any emerging economy could be immune to global volatility, those with strong macroeconomic fundamentals and a stable of competitive companies remain the world’s likeliest source of long-term growth.”

In a recent roundtable discussion, Mirko Cardinale, head of investment strategy and advice at USS said: “Emerging markets are not a very homogeneous group – they are very different, so you have to be selective.”

Asset management firm Edmond de Rothschild shares this view, stating: “Emerging markets are benefiting from favourable trends where select countries and sectors offer real opportunities.”

Currency plays are also a potential source of return. Emerging market currencies have experienced a strong rally, gaining over 10 percent since the pandemic broke out. Despite some investors expressing concern about the asset class getting expensive, James Barrineau, Head of Global EMD Strategy, Schroders believes the rally still has legs, noting this view fails to take into account the damage done by the 2013 Taper Tantrum. This was an event which triggered a spike in US Treasury yields when the Federal Reserve announced it would be tapering its quantitative easing programme.

In a briefing note, Barrineau asserts: “Even with some recent deterioration, surpluses are very near 20-year highs. For us, that represents a margin of safety against a Federal Reserve (Fed) taper that might come sooner than thought a few months ago. Continued slack across economies, even as growth resumes, makes it unlikely that we will see a return of structural inflation eroding currency value.”