5 Things to Know About Emerging Markets Investing

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Emerging market fixed income is less concentrated than equities

Emerging markets debt and equity have many overlapping traits, but also differ in their exposure to countries and risks. The MSCI Emerging Markets Index contains 27 countries, with the five largest accounting for 70% of market value. Three countries in Asia - China, South Korea and Taiwan - comprise more than 50% of the index.

Compared to equities, the fixed income universe is more diverse. The JP Morgan EMBI Global Index, which includes dollar-denominated debt issued by emerging market countries, contains 66 countries. The largest five countries account for only 40% of market value, and the top three for 28%. Of the 66 countries in the emerging market fixed income benchmark, only 19 countries overlap with the equity universe.

"EM equity and debt are distinct asset classes. Investors should allocate between the two based on the risk profile desired."
Yacov Arnopolin, Portfolio Manager

Emerging markets include commodity importers and exporters

Although some countries are heavily dependent on oil exports, across the wider emerging market universe – and specifically in South East Asia, Eastern Europe and the Caribbean – many countries are net importers rather than exporters. Even Mexico, commonly perceived as a significant exporter, imports oil and exports refined products.

Hence low commodity prices are not necessarily bad for emerging markets. They can come as a relief for importing countries as they improve their current account balance. On the other hand, very high commodity prices are not necessarily good as they may encourage a lack of fiscal discipline among exporter nations. This divergence between importers and exporters can be positive for active investors as it enables them to differentiate within the universe.

"We think oil prices will be range bound in the near-term. This can be a sweet spot for emerging markets."
Yacov Arnopolin, Portfolio Manager

Emerging market crises have become more contained

In the early days of emerging markets investing, trouble in one country could quickly spill over to another. Events such as the Tequila crisis in 1994, the Asian crisis in 1997, and Russia's default in 1998, all contributed to the perception that emerging markets were prone to "contagion risk".

However, growing investor sophistication has led these types of events to stay more isolated. Political upheaval in the Ukraine, which started in late 2013 and led to Russia’s annexation of Crimea and the downgrade of its debt by rating agencies, prompted many investors to pull out of Russia. However, rather than leave emerging markets entirely, fixed income investors rotated into the bonds of other commodity producers like Kazakhstan.

Of all countries, China has the potential to generate the widest reverberations. However, the impact on EM debt investors could be mitigated by two factors. First, the main emerging market debt indices do not include Yuan-denominated Chinese bonds, and second, a slowdown in China could trigger looser monetary policy, which would be positive for fixed income investments.

"EM has evolved a lot. Country specific events are more contained and markets less susceptible to panic."
Yacov Arnopolin, Portfolio Manager

Higher U.S. interest rates are not always bad for emerging markets

With the notable exception of the "taper tantrum" in 2013, emerging markets credit has held up well in prior periods of rising U.S. interest rates. Currencies have posted patchier performance, but debt denominated in hard currency (USD) has been more resilient. Both asset classes delivered positive performance across the tightening cycles in 2000-2001, 2004-2006, and in the current cycle to date.

Differences in real yields between developed and emerging markets, which are a function of inflation expectations, are the primary driver of local debt performance. At present real yields are significantly higher in emerging markets, providing a significant buffer to EM performance in the event of further U.S. rate rises.

The current rate cycle is also one of the most well communicated in recent history, and any tightening of financial conditions should coincide with improving growth and trade volumes. Higher U.S. interest rates are therefore far from a "nightmare" scenario for emerging markets.

"The wide real-yield gap means EM debt will likely be less sensitive to higher rates in developed markets."
Yacov Arnopolin, Portfolio Manager

Frontier markets remain small and illiquid

With emerging markets becoming an established asset class, many investors have sought the next big thing. Frontier markets - a broad term applied to countries as distinct as Uruguay, Zambia and Sri Lanka - have been positioned as that. However, the only common traits these countries share are having small economies and often less liquid bond markets.

Although frontier markets can offer higher yields, their future performance depends on improving transparency, diversifying their economies and engaging local and international investors.

"There is no guarantee that frontier markets will outperform emerging markets"
Yacov Arnopolin, Portfolio Manager

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Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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