In recent years, investors have viewed emerging markets a bit like marmite, the distinctly flavoured spread made from brewer’s yeast: they either like the allocation or they don’t.
Witness Swiss pension fund Compenswiss, at the sharp end of weak passive performance in emerging market equities that chief investment strategist Frank Juliano attributes to the dominance in the index of poorly performing China A shares.
“We plan to decrease our allocation to emerging market equities as we do not expect China to outperform in spite of the recent stimulative measures.”
For others, emerging markets remain an important source of diversification and return. At the £14 billion TfL Pension Fund, an open scheme for workers across London’s transport network, chief investment officer Padmesh Shukla oversees diversified opportunities in emerging market public and private equity, debt, infrastructure, and even hedge funds.
“Emerging markets provide one of the highest equity risk premiums, although that hasn’t been the case now for some time. We are not looking to unwind our exposure, majority through active mandates, because it is consistent with our long-term investment thesis, providing diversification and unique growth opportunities.”
Many investors see the opportunity in emerging markets’ favourable demographics, growth and maturing capital markets that are transforming liquidity and diversification opportunities. But worries about China, governance, and performance paling in comparison to US equities, seem to have left others on the sidelines.
For example, Canada’s $675 billion CPP Investments has seen strong returns in emerging market infrastructure, particularly toll roads in Mexico, Chile and Indonesia, and renewable energy in India and Brazil. But Ed Cass, chief investment officer of CPP Investments, says geopolitical risk and improving market efficiency is changing opportunities, and the fund is investing less than before.
“Our exposure was 22 per cent at the end of fiscal 2023. Since then, we have already transitioned towards our revised long-term strategic portfolio exposure target of 16 per cent.”
Colin Purdie, global chief investment officer of public markets at Manulife Investment Management believes successful investment rests on embracing an alpha play that involves picking investments according to different growth rates and capital market assumptions.
Active investment is not just a way to skirt the impact of crisis in China’s property sector and weak domestic consumption weighing on the broad index. Stock picking enables investors to focus on emerging names and escape the dominance of commodity plays, state-owned companies and old economy industries in the index where capital allocation is less efficient and governance weaker.
“The returns are still on offer, just not at a market level as a whole,” he says.
He believes the prospect of tariffs makes active management even more compelling: GDP in Mexico and China could suffer but countries like the Philippines, Thailand and Indonesia may do well from accelerating supply chain shifts.
Meanwhile India’s economy is insulated by domestic demand and local consumption. In another scenario that also speaks to the benefits of “picking your spot,” Purdie says China’s response to tariffs could be positive for the domestic economy if more fiscal stimulus comes through.
China is too big to ignore
It leads him to reflect that investor confidence in China could rebound if government efforts to kick start the economy start to bear fruit.
Global institutional investors like $203.7 billion Teachers Retirement System of Texas and Canada’s $110 billion Healthcare of Ontario Pension Plan (HOOPP) have whittled down their exposure to China to close to zero, and domestic investors are also under-weight.
But a return to stability could see an outsized move if domestic investors put their money to work.
Moreover, many investors are sitting with a positive tilt to India but may not stick with India where valuations are relatively stretched, if momentum returns to China.
“With valuations at cheap levels and extreme under-ownership, a sustained fiscal and monetary stimulus will trigger further equity performance. The CSI 300 is up 25 per cent from the end of September post the initial central government directive on stimulus. This will clearly need to be countered with what appears to be an increasingly hawkish rhetoric from the new US administration,” he says, adding: “Previous stimulus has triggered a trough to peak move in China of 30 per cent. The idea that India is the new China is a lazy narrative. China is too big to ignore.”
The attraction of emerging market debt
Purdie believes emerging market debt offers one of the most compelling investment opportunities in the current market. Manulife Investment Management approaches the allocation with strong conviction backed by fundamentals. The team breaks risk factors down to their country and sector level, evaluating geopolitical risk and potential changes in the sovereign rating that could alter a corporate credit profile and flag potential liquidity squeezes.
Recent debt restructuring in Ukraine, Zambia, and Egypt illustrated the dependency of emerging economies on international commitments and loans coming through. For example. Egypt’s receipt of $57 billion in global aid changed investors’ perception and stemmed outflows in the wake of the sovereign downgrade.
Active duration positioning also makes money and supports portfolio construction by introducing hedging tools. If investors are positioned in a name, country, and sector that suddenly performs poorly, a duration position can protect them on the other side.
“Risk off moves come through quickly in emerging markets. Treasury yields come down and prices go up and this can act as a good hedge. It’s an important tool in portfolio construction” he says, adding that if lower rates materialise in developed markets, flows into emerging market debt will also pick up.
“Higher rates in developed markets have dented investor enthusiasm for emerging market debt because they don’t need to stretch into other areas for yield.”
Getting the governance right
Commentators say governance is perhaps the most important risk to navigate. History isn’t short of examples of investors putting the hunt for yield before governance in emerging markets. For Purdie, one of the most infamous is investor losses from sterling-denominated Kazakhstani bank bonds in 2008.
“Investors were so keen to get involved because there was a bit more of a spread, but they didn’t price the governance right,” he recalls. “Nothing makes a bond go from par to zero quicker than governance, particularly if it’s related to fraud.”
This governance risk is the main reason private credit isn’t included in TfL Pension Fund’s extensive emerging market allocation, explains Shukla.
Uncertainties around the rule of law and bankruptcy processes can leave investors out of pocket, particularly because the position of private credit in the capital structure can limit the ability to enforce security.
Boots on the ground
It’s why hands-on investment is crucial. Manulife Investment Management and CPP Investments have local teams in emerging markets to bring essential best practice, depth, skill, and experience to manage assets both internally and with local external partners.
“We believe that one of the keys to success is to have boots on the ground,” says Cass. “We have offices in key markets, which allows us to better understand the businesses we invest in and the environment in which they operate. It also positions us to partner with the best regional and national firms.”
Similarly, Manulife Investment Management’s on-the-ground analysis goes beyond knowing the corporate to building relationships with government representatives and authorities to understand the local market and culture. It ensures the team get in front of any red flags, especially sudden bouts of illiquidity that can make it difficult for investors to exit.
It also informs Purdie’s cautiously optimistic view that momentum might return to China off the back of more government fiscal stimulus.
“The local view in Beijing is that the government will do more,” he concludes.
