The challenge develops in emerging markets

Written By: Matthew Craig LAPF Investments

Matthew Craig examines the evolution of emerging markets, and looks at how LGPS funds are adapting to the challenges

As far as Local Government Pension Scheme (LGPS) and other long-term, institutional investors are concerned, the emerging markets are a fertile and important part of the investing universe.

This has been the case for some time, probably since the emergence of the BRICs theme in 2001, if not before. The BRICs acronym was the brainchild of the then Goldman Sachs economist, Jim O’Neill, who put together Brazil, Russia, India and China (South Africa was added later), pointing out their shared characteristics and potential for growth. Since then, other countries, such as the next 11 emerging markets of Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, Turkey, South Korea and Vietnam, have come under scrutiny from investors in the LGPS and elsewhere. In addition to these countries, emerging markets can encompass Central and Eastern Europe, Latin and Central America, as well as the larger and more developed Asian, African Middle Eastern countries.

Why are these countries so interesting and potentially rewarding for investors? The main reason is the potential for higher economic growth rates than the developed markets of Europe, North America and Japan. Research has shown that emerging market growth rates have been around 2% a year higher than developed markets, although this is accompanied by higher volatility and periods of underperformance.

For LGPS funds, emerging markets were a good source of returns in 2017, as were most asset classes. The £4.5 billion East Riding Pension Fund is a good case in point here. It has a relatively modest allocation to emerging market equities of 3.6%, but this returned 35.2% in the year to 31 March 2017, as the global economy performed well and UK investors enjoyed a boost in overseas equity returns from sterling depreciation. In its annual report, the fund noted: “The best performing equity region, in sterling terms, was Pacific ex-Japan (36.3%) due to a recovery in commodity prices and its proximity to Asian emerging markets which experienced an improvement in economic growth. Emerging markets also benefited from an improvement in economic growth in the region as well as its relatively high valuation discount to developed equity markets.”

It is worth noting that the East Riding fund also saw a 35.4% return from global high yield and commented: “Emerging market bonds were very strong, driven by income and a reduction in yields. Local currency bonds benefited further from a stabilisation in emerging market currencies.” In fact, while emerging market equities have attracted investors for a long time, the search for yield in fixed income is leading to a growing interest in emerging market debt, either as part of broader or more specific allocations outside core fixed income. According to the JP Morgan EMBI Global bond index, emerging market bonds have returned 12.2% in US dollar terms since 1991, compared to 5.5% for US Treasury bonds over the same period. At the same time, statistics show emerging market bonds are more than twice as volatile as US Treasury bonds, with average volatility of 10.1% from 1994 to 2016, compared to 5.5% for US Treasury bonds.

It is important to bear in mind that emerging markets have evolved hugely over recent years. NN Investment Partners head of emerging market debt, Marcelo Assalin, recently commented on how emerging market debt has changed over the last 25 years, saying: “The opportunity set has evolved considerably and markets themselves started to converge towards their more developed counterparts in terms of investors’ perceptions. Collectively, these countries have undergone dramatic economic improvement and today they present a compelling source of differentiated returns for investors of all types.”

Assalin picked out a number of themes for emerging market debt. One is that ailing countries can have the ability to bounce back quickly because they are supported by organisations such as the World Bank and the International Monetary Fund. “For the more committed investor, investing in distressed countries can present excellent opportunities to invest in a country’s bonds at highly discounted levels.” Another lesson is that the days of a simple and sweeping BRICs theme – as a rising tide that lifts various emerging market vessels – are over. The concept was partly based on the demographics, industrialisation and natural resources creating the right conditions for growth for emerging markets, but Assalin commented: “Two decades later these beliefs proved to be unfounded as falling commodity prices, declining global trade and mounting debts took their toll, particularly on Russia. The emerging market universe is extremely diverse and investors must not lose sight of the idiosyncrasies within countries.”

Of the BRICs quartet, China has clearly advanced the fastest since 2001, to the point that it is challenging the US position as the dominant economic and political superpower. This means it now has huge influence over other emerging markets. For example, it is now funding infrastructure projects in Africa as part of its ambitious “One Belt, One Road” strategic plan to develop trade and economic development through central Asia and the Middle East on the lines of the old Silk Road. Assalin commented: “China’s growth rate will likely decelerate in the medium term on the back of structural reforms that it must make as its economy matures and, given the extent of its influence, this could have far reaching negative implications. Investors will therefore need to closely monitor China’s economic progress over the longer term.”

This raises the point that emerging markets can be heavily affected by geopolitical risk, or heighted volatility. The prospect of a full-blown trade war, sparked by President Trump’s decision to slap tariffs on steel and aluminium, is one possible catalyst for this. Lombard Odier IM chief investment strategist, Salman Ahmed, commented that move could increase the possibility of a US-China trade war. Despite this, he is currently remaining positive on emerging market: “We see the current trade frictions as more of a one-off than the start of a trend. However, volatility is here to stay, and may start to affect emerging markets on a more sustained basis. In that context, seeking downside protection may be a key attribute when it comes to portfolio construction.”

For the LGPS funds, the asset pooling exercise could cause a reassessment of the role of emerging markets. On one hand, the emerging markets are growing in importance as part of the world economy. Investors are also comforted by improving liquidity and transparency in parts of the emerging markets, the emergence of local investors and domestic stock markets, and greater political and economic stability. However, LGPS funds are becoming more mature, and moving to an era when capital protection and income generation will be more important, at the expense of growth. Emerging markets will have to fit into this framework. The asset pools also need to produce the investment vehicles that the underlying local authority funds want to see. In some cases, this may mean emerging market equity and bond funds, but there is also a trend towards fewer, larger funds which are based on strategic aims of growth, liability-matching or income, with greater freedom to invest widely to meet a particular need. This could mean emerging market assets have to fight for their place in the investment mix, rather than having a specific allocation made to them.