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Normandin Beaudry

Investments in emerging markets, still attractive?


There, in black and white

NB Bulletin Vol. 16 N. 16, November 2013

Since the financial crisis of 2008, bond interest rates and economic growth forecasts for developed markets have declined dramatically. As a result, many investors turned to emerging market equities and bonds in search of higher expected returns.

In 2013, it appears that investors are turning their backs on these markets, as evidenced by the capital outflows in both bonds and equities1. The table below compares the performance of emerging market bonds and equities with that of developed market equities.

Does the significant return differential in favour of developed market equities challenge the long-term potential of emerging market equities and bonds? 

The JPMorgan EMBI Index and the MSCI Emerging Markets Index (MSCI EM) have been posting negative returns since the beginning of 2013, whereas developed market equities have posted a return of 21.3%. Returns for the MSCI EM Index for the past three years have also been negative. It should be noted, however, that performance varies considerably from one country to another, as illustrated in Table 2. 

For the past three years, the BRIC countries (Brazil, Russia, India and China) have not performed as well as other countries in the MSCI EM Index. China maintained annual growth of close to 10% from 2000 to 2010. However, following the arrival of a new government, China’s annualized growth rate has slowed to around 7% in recent quarters (according to data provided by the National Bureau of Statistics of China). The objective of these changes is to achieve sustainable long-term growth. 

This slowdown, combined with a potential gradual decrease in bond purchases by the U.S. Federal Reserve announced last May, has caused investment activity to cool for certain investors who were borrowing in the United States or in other developed markets at interest rates around 0%, to subsequently invest in emerging market bonds (carry trade). Since then, due in part to the closing of carry trade operations and the concerns associated with the economic strength of the country, India’s currency depreciated by more than 10% following the massive sell-off of assets. Other emerging markets in the region also experienced capital outflows, which negatively impacted bond and equity returns. 

Some institutional investors draw a parallel between the current climate and the financial crisis of the 1990s that affected emerging Asian markets, more specifically, countries that had pegged their currency to the U.S. dollar and had sizeable budget and trade deficits. However, a few noticeable differences are that most emerging market currencies now fluctuate freely against the U.S. dollar, and the governments of these countries are no longer heavily indebted. In short, their economic situation is not as precarious as it was 20 years ago. In recent months, the emerging markets have reacted swiftly, creating a $100 billion currency stabilization fund designed to offset potential currency fluctuations. 

This downturn presents buying opportunities for other investors who do not see it as a structural change for them. It is the result of the influence of the central banks of developed countries and their accommodating monetary policies that are injecting billions of dollars in cash into the financial system. Moreover, based on various financial ratios, the valuation of emerging market equities appears to be more attractive when compared to developed market equities. 

The underlying reasons for investing in emerging market bonds and equities are still present: 

  • Young and growing population
    • 80% of the world population
  • Governments close to achieving a balanced budget and whose debt level as a percentage of gross domestic product is lower than that of developed countries
  • Better outlook for economic growth
    • Expanding middle class
    • Increased access to credit 
  • Major stock market and currency diversification benefits
    • 50% of the world’s gross domestic product at purchasing power parity 

The arguments that support investing in emerging market equities are for emerging market bonds. The risk premium is in some cases more attractive for higher credit quality measures than in developed markets. The yield to maturity for the JPMorgan EMBI Index is 6.0% as at September 30, 2013, as compared to 2.7% for Canadian bonds. However, some risks (economic, political and currency-related) remain and the economic environment poses challenges for these economies. Returns should however offset risks both for equities and bonds. 

Finally, according to the Normandin Beaudry Investment Funds Universe comprised of nearly 50 emerging market equity funds, the first quartile manager adds more than 3% compared to the MSCI EM Index over the past four years, which argues for active management for this asset class. 

1BlackRock report on capital flows between the different asset classes.


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