Emerging markets- an opportunity or a threat?

Emerging markets (EM) have over the years offered very generous returns to investors, despite the fact that the sensitivity to both commodities and the movement in the dollar currency have always been seen as a threat to the said regions. I recall very clearly the sensitivity felt by investors in June 2013, when markets priced-in signals of tapering by the US Federal Reserve. That month, emerging market bonds were hammered by 10 percentage points. At the time, market participants described the uncontrollable outflows as a market segment which was bleeding blood in the streets. Following that correction, EM bonds rallied the way over to lock remarkable annualised returns.

There is much to say why EM countries do offer an opportunity to investors. Few may be aware, but in reality selective EM countries are much better positioned than developed economies from a fundamental perspective. Looking at the debt-to-GDP ratio, on average in the Euro-area, this figure currently stands on the highs of 89.2 percent, with the main countries contributing to these levels being Greece, Italy and Portugal, which currently have debt-to-GDP levels of 179, 132.6 and 130.40 percent respectively. On the contrary, many EM countries have low levels of debt-to-GDP which gives such Governments more lean-way in terms of fiscal expenditure. Few examples, which come into mind, are Chile (21.3 percent), Colombia (47.6 percent), Mexico (47.9 percent) and Indonesia (27.9 percent).

One other huge positive, which is a crucial element in terms of contribution towards GDP growth, is demographics. It is a known fact that the age group between 0-15 years, i.e. the group that will be forming part of the labor force in the future, is high for EM countries. For instance, in China it is at highs of 25 percent, whereas in Germany it has decreased over the years to levels of circa 12 percent. This is another important feature why EM countries are still registering high single growth digits, as opposed to the circa 2.5 percent growth figure being registered in the Eurozone area.

Another important aspect are the low levels of GDP per capita levels in EM countries which are still on the very low side when compared to developed economies. The economic thought of economic convergence would imply that developing economies would converge towards the developed also in terms of per capita growth. In reality, over the years we have seen a shift in EM countries from the lower class to the middle class, which ultimately raised the standard of living and thus GDP per capita. There are roughly 60mn people a year entering the Chinese and Indian middle class, that’s about the population of Italy. This is another argument in favor of more positives to come in terms of economic growth in such regions.

Not all is rosy though, the main threats in such regions are mainly corruption issues, poor corporate governance and liquidity risk. That said, nowadays market participants have got use to the corruption element, and at times this is seen as opportunity to dip-into the market accordingly. Case in point is Brazil which is surrounded by scandals whereby the country however is still delivering in terms of returns.

In my view, an EM allocation should be considered within a portfolio. Being selective is imperative to generate the desired objectives. For instance, for those investors who are concerned of the region’s sensitivity to the USD dollar, nowadays selective EM corporates themselves are holding USD cash on their balance sheet, which is acting as a natural hedge for servicing financial costs. Indeed, EM are still offering a return which is above the average returns generated in the Eurozone area. These regions have much to offer in terms of growth, which will ultimately be reflected in asset prices. Be positive, take the plunge, and consider an allocation despite some might be skeptical.