Emerging markets (EM) have beckoned investors seeking to achieve high-return targets. As recent developments have clouded the turnaround story of EM equities, investors may want to consider EM debt to help close the return gap. Gaurav Mallik, Global Head of the Equity Portfolio Strategist team, and Niall O’Leary, Head of EMEA Fixed Income Portfolio Strategy at State Street Global Advisors, answer investors’ questions.

Q: What has changed in EM equities?

A: One of the reasons investors are attracted to EM equities is the promise of growth opportunities, given the faster pace of expansion in emerging markets relative to developed markets (DM). However, the picture is evolving. The gap between EM and DM growth, valuation and profitability premia are shrinking, suggesting that investors may need to consider a fresh approach. We see three key challenges in EM equities.

Gaurav Malik
  • One, the spread between EM and DM GDP growth rates has been shrinking as China’s economic expansion has slowed. The steady advance of technology and automation is eroding EM’s primary competitive advantage – cheap labor. We have also seen a sharper pickup in manufacturing purchasing managers’ indices (PMIs) in DM than in EM over the past four years.
  • Two, on a valuation basis, EM equities may not be as attractive as they seem and investors need to be careful to avoid stepping into value traps. Bear in mind that the state-owned entities (SOEs) prevalent in the energy, materials and financials sectors account for roughly half of the MSCI EM benchmark. SOEs are essentially bets on structural reform to open up closed economies and to bring in foreign investors by privatizing banks and energy companies. But such events are hard to predict. Our analysis found that once we adjust for SOEs, we no longer see the same depth of discount.
  • Three, while EM margins historically exceeded DM margins, that trend has reversed as EM margins have eroded since the global financial crisis. The return on equity (ROE) has not exceeded the cost of equity (COE) in EM for the past eight years.

Q: How can investors adapt to these challenges?

A: Investors have to be selective within EM equities, especially among smaller companies that have less of a multinational focus and more exposure to domestic economies. That’s why we think it makes sense to take a fundamental approach to stock selection whether focused on growth or value, to seek those firms that can reap the greatest benefit from the current reflationary environment. For MSCI EM Index investors, the good news is the benchmark itself has evolved — with the problematic materials and energy sectors shrinking in share while information technology has expanded to roughly the same weight as in the S&P 500 Index. But given the various idiosyncratic drags on the index, investors may want to consider an enhanced indexing approach to EM equities.

Q: Turning to EM debt, what opportunities does the asset class offer in today’s market?

A: On the EM debt side, we find a large, diverse and relatively liquid market that may help close the income gap at reasonable risk. The low-yield environment has made EM debt valuations compelling. When we consider performance in terms of return per unit of risk, we find that EM debt at the index level has provided more income than DM bonds while also acting enough like a growth asset to outpace EM equities. And investing in EM debt has provided diversification, thanks to the low-to-moderate correlation with equities and fixed income across the globe.

Niall O'Leary

Q: How can investors access this opportunity?

A: The lackluster recent track records of most active managers have prompted investors to reconsider more passive or systematic EM debt managers. As one of the global leaders in index investing, State Street Global Advisors welcomes this trend, as we consider indexing to be a truly credible alternative that can address the behavioral biases exhibited by traditional active EM debt managers. And with EM currencies moving from being overvalued to moderately undervalued as global growth improves, we view this as an attractive entry point for new investors and a great way to get exposure to EM.

For more details, download Emerging Markets: Opportunity, Trade or Value Trap?

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