The dramatic evolution of emerging markets over the past 30 years means that investors cannot look at them through the same lens. Even the term ‘emerging markets’ now refers more to a benchmark classification rather than its distinctive fundamental factors.
Led by China, EMs are now one of the most important drivers of global economic growth. And with key longer-term aspects like urbanisation, productivity, and for many EM countries, far more attractive demographics, opportunities for investors abound.
The transition of China from a manufacturing-led to a service-led economy is changing the perceptions of EM once and for all: over the last five years, the relationship between commodity prices and EM equities has weakened significantly, while information technology, the internet and consumption have taken over.
But it has not been all rosy for EM. Significant headwinds, such as the bursting of the commodity bubble, China’s slowdown, weak global exports, and the strong US dollar, have meant adapting your style of investment.
EM has also experienced a narrowing of the economic growth premium versus developed markets, while corporate earnings growth has been weaker due to a combination of cost pressures (including wage growth) and softening demand.
Currently, EM faces a two-pronged threat from trade tensions between China and the US, and the global health crisis. The coronavirus outbreak has negatively impacted EM currency markets and exacerbated the general sense of unease.
EM hasn’t seen the same gains markets such as the US have seen over recent years, but there are still many positive options for EM equities while remaining selective.
On the bond side, with roughly $15tn in developed market debt offering negative yields, EM debt remains attractive, especially EM corporates, T. Rowe Price managers point out.
‘Many regions and sectors offer defensive qualities that can outperform other asset classes during periods of risk aversion,’ says Andrew Keirle, portfolio manager Emerging Market Local Currency Bond strategy at T. Rowe Price.
‘EM corporate debt is now a larger market than US high yield or EM sovereigns, with over $2tn in bonds across 50 countries.
Within this scenario, where is the next wave of EM opportunities coming from?
Scott Berg, portfolio manager, Global Growth Equity strategy at T. Rowe Price says that 2020 is going to require ‘some nimble movement’ in portfolios with the most interesting areas to explore to be found in demographically-driven areas, such as India, Indonesia, the Philippines, Vietnam and Peru.
The growing population and consumer-led lifestyle of these countries creates a favourable backdrop for higher pricing power, positive real interest rates and stable inflation.
This is fertile environment for traditional banks and consumer companies to prosper, explains Berg.
On the other hand, the fund manager is underweight commodity-levered economies—such as Russia, South Africa, Brazil, and the Middle-East given the less bullish outlook for commodities.
‘Within very selective pockets of these economies, we are focused on companies with growth leveraged to positive consumer trends and emerging technologies, including electronic payments. High-quality balance sheets, low-cost production, and better growth profiles remain our compass in tougher neighbourhoods,’ says Berg.
Turning to specific companies, investors should think carefully about who is profiting from EM economic growth. As Vaishali Lara Kathuria, an EM equities analyst  at Norges Bank Investment Management, explains, this often gets overlooked.
‘While investors might be quick to identify the income effect of economic growth in EM (for example when disposable income increases, people tend to obtain bank accounts), they tend to overlook how consumer preferences change.’
As part of this analysis, EM investors should consider the opportunities of digital innovations, particularly those that address existing bottlenecks. With their enterprising young populations, freed from tradition or legacy, EM countries are eagerly embracing technologies in the FinTech arena and creating miniature versions of Silicon Valley from Jakarta to Nairobi.
From global to local
Overall, with this ongoing trend toward more domestically driven economies, EM fundamentals are becoming more localised, making broad generalisations about the asset class less relevant. One only needs to look at performance on a country‑by‑country basis to see that they cannot be viewed under one homogenous banner anymore.
This ongoing change represents both a challenge and an opportunity. The playbook for allocating to EM equities and bonds is no longer solely cyclically driven. If in the past asset managers were posing questions on global growth, commodity prices, EM currencies, today the picture is much more complicated. While these factors are still important, they are part of a much broader mosaic.
The past trajectory of EMs and winners at the individual security and country levels will not be the same going forward. A deep understanding of the opportunities and thoughtful security selection will be key to delivering results in these markets.