The case for emerging market investing rests on three pillars: diversification, return enhancement and access to a broader set of investment opportunities. A portfolio that includes emerging markets can be less volatile and enlarges the number of companies available to an investor.
Undoubtedly, cyclical factors such as the global boom of the past four years and low nominal and real interest rates have helped to fuel the powerful rally of recent years.
INCREASING ATTRACTIVENESS
However, there are several long-term forces at work in the world economy that are increasing the attractiveness and accessibility of emerging market assets and leading to a reduction in the required risk premium. These include:
1)Aging populations in the developed world and anticipated slower growth rates in industrial economies as the baby boomers retire. A recent study by the U.S. Federal Reserve concluded that annual potential output growth in the United States will decline by roughly 25 basis points because of a decline in the growth of the labour force. In the aggregate, real earnings per share growth, over time, tend to track real growth in output.
2)As developed country investors reduce their long-term return expectations for their domestic market, they are likely to reduce their “home bias.” This bias is gradually, but inexorably, falling. Emerging Asia is growing nearly three times as fast as the rest of the developed world. Flows to emerging markets are likely to increase given the relentless quest for return and the prospects for more rapid earnings per share growth. These flows will help support the asset class.
3)Less volatile inflation and business cycles in both the developed and emerging world. In the conduct of macroeconomic policy, as in medicine and other fields of endeavour, there is a cumulative learning process. Policy mistakes are a permanent feature of the economic and financial landscape, but the lesson that inflation is inimical to growth has been learned. Fluctuations in output are less violent, which, in turn, helps to reduce the risk premium required for emerging assets. A reduced risk premium implies that there is scope for further p/e multiple expansion.
4)Sharply improved resilience to shocks and more market-oriented macroeconomic policies. Many emerging markets have experienced a significant improvement in their terms of trade. In addition to favourable gains in terms of trade and the substantial buildup reserves in many countries, in several cases budget deficits are declining, foreign debt is being paid down, local financial markets and instruments are developing rapidly and integration with the world economy is ongoing. Of course, progress is not uniform. But the improved position of several emerging markets is likely to lead to increased investor interest.
5)The emergence of more competitive firms located in emerging markets and the rapid diffusion around the world of productivity-enhancing technologies have also led to the attraction of emerging markets for institutional investors.
Other drivers of emerging markets include China as not just a global supply shock but also a global demand shock, the continued growth of outsourcing to India and elsewhere, the wiring of the emerging world and selected improvement in corporate governance. Asian currencies can also be expected to revalue, thereby enhancing investor returns.
The implications of these developments for Canadian institutional investors are clear. Emerging markets are in a secular improvement and should form a core holding in investors’ portfolios.
George Hoguet, CFA, is a global investment strategist with State Street Global Advisors in Boston.
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