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Emerging from lockdown

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10 July 2020

Why Emerging Markets offer a particular opportunity post COVID.

Now might not seem the obvious moment for advisers and investors to raise the risk profile of their portfolios; the volatility in financial markets caused by the Covid-19 pandemic this year is unnerving enough. But amid the gloom, there may be a case for taking another look at emerging markets – preferably through a well-managed investment company.

What we do know is that emerging markets are under-represented in investors’ portfolios today. The world’s developing economies already account for more than 50% of global GDP, and this is expected to rise to close to two-thirds by 2022. The stock market capitalisation of businesses in emerging markets currently accounts for 20% of total world capitalization, having risen 10-fold in recent decades. Yet many investors continue to hold little or no emerging markets assets.

The long-term structural attractions of emerging markets are widely recognised. These economies are less mature in their development and therefore offer higher rates of growth as they catch up. They are home to rapidly growing middle-class populations - by 2030, the global middle class is expected to reach 5.3 billion, with 40% living in China and India alone – with all their spending power. And they are often rich in natural resources.

But while many investors recognise the arguments for increasing their exposure to emerging market assets over the long term, they have been reluctant to take the plunge. There is always a reason to put off increased investment in an asset class seen as prone to excess volatility.

The recent performance of emerging market equities has not helped. In the first decade of the 21st Century, emerging markets outperformed their developed counterparts by a significant margin. Since the financial crisis, however, this outperformance has been reversed, as risk-averse investors worldwide have shunned emerging market assets.

So why might now be a turning point? Well, one argument is that the Covid-19 pandemic has put paid to the idea that emerging markets are best avoided in a crisis. Some developing economies are faring badly during the pandemic, but others have coped much better – China and South Korea are obvious examples. Many Western countries have much to learn from these nations.

Another important point is that we now look set for a challenging period of market performance in an era where central banks have felt compelled to slash interest rates to offer some protection from the pandemic. Economic recovery looks a long way off in many countries, despite the initial hopes of a V-shaped bounce. In which case, higher-growth markets have much to offer.

A third argument in favour of emerging markets today is that many are well-placed to benefit from a reshaping of the global economy post Covid-19. Markets beyond China, for example, will take advantage of an international shift to diversify supply chains as businesses worry about over-reliance on individual countries.

None of which is to suggest we are about to see a sudden surge in emerging market performance. But there is a case for some counter-intuitive thinking. At a time when increased risk aversion might be expected, many investors need to take a fresh look at how and where they invest.

Investment companies, of course, offer an ideal route into emerging markets. They offer active management, which is important in markets where returns are highly dispersed and opportunities to outperform are more widespread than in regions such as the US, where passive styles have become so dominant. Crucially, they also protect investors from liquidity issues, which can cause problems in emerging markets – the structure of an investment company provides important insulation in that regard.

Is now the moment to invest? Well, that’s an individual decision, depending on personal circumstances and financial objectives. But emerging markets investment companies do offer some attractive valuations right now – most of the global sector, for example, trades at a chunky double-digit discount to the value of funds’ underlying assets.