Emerging markets: What you need to know

26 March 2018 | Webinars


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Emerging markets offer a wealth of opportunity for the long-term investor, but what are the shorter-term risks? How important is political risk? Is growth on course? Is government debt likely to be an issue? Do we need to distinguish between regions? What will be the impact of winding down quantitative easing?

Jonathan Lemco, senior investment strategist, and Nick Eisinger, head of active emerging markets fixed income, speak to Leo Schulz about the risks and opportunities for investors.

Leo Schulz: Emerging markets – what you need to know. Emerging market equities have returned around 400% since 2000. There have of course been periods of setback and underperformance, but since 2016 the asset class has gone from strength to strength, whether you’re investing in equities or in bonds. Is this the beginning or is this the end?

My name is Leo Schulz; I have with me Nick Eisinger, our head of active emerging market fixed income based here at Vanguard’s London office, and on the phone from our Pennsylvania headquarters, Jonathan Lemco, a senior investment strategist with a leading role in our emerging markets research. And Jonathan, I believe, will be attending the International Monetary Fund conference in Washington DC later this week, where he will be meeting a great many people with high profile roles in emerging markets.

Welcome to you both. If you have trouble with the quality of the audio there should be a window on your screen giving instructions on how to dial in directly on your phone, and this should help to give you a nice, clear sound. To our live listeners, you should soon see a box into which you can type questions. We have quite a large audience today, so if we don’t get to you personally, we will definitely follow up.

The call will last approximately thirty minutes; the webinar earns participants a half hour’s worth of CPD points. You will need to request your certificates by contacting your usual Vanguard representative, by writing to, or by phoning 0800 917 5508. Don’t worry if you didn’t quite catch that, I’ll bring the details onto the screen at the end of the call.

So today’s agenda: strong, recent performance but what’s next? There are of course risks: trade wars, the end of QE, conflict risk, a lot has been in the news lately, and political populism; opportunities – we’ll be looking at some of the newer markets that have come onto the radar, and then we’ll be looking at the role of emerging markets in a portfolio.

What we have here: positive fundamentals; the green line is equities, and we can see the upturn since 2016. The orange line with the dots is emerging market GDP over and above developed market GDP, so that’s a positive difference being forecast there, and then the blue line is the spread, which is the difference in yields between emerging markets and developed markets, so again looking at the strength of emerging market debt.

I wonder, Jonathan, could you just give us an insight into what are some of the key attributes that are underpinning this positivity in emerging markets?

Jonathan Lemco:  I’d be happy to and thank you for giving me the opportunity to speak to your audience. We’ve seen macroeconomic fundamentals since roughly 1997/1998 in much of the emerging market world improve substantially.

From a fixed income perspective we pay very close attention to the fiscal side, to debt, and debt to GDP ratios in emerging markets have improved enormously since the Asian financial crisis of 1997/1998.

Policy makers in Asia and in Latin America learned their lessons frankly. In many cases they let their currencies float more freely than they had in the past and we saw more fixed exchange rates.

They stopped investing in a lot of infrastructure that often would have been bridges to nowhere; stopped wasting money in so many cases.

The bottom line is debt to GDP improved and many of these countries that had been junk-rated at that time, are now solidly investment-grade, such that from the perspective of Moody’s, Standard and Poor’s, and Fitch, the three most prominent ratings agencies, now a majority of EM countries are rated by them as investment grade, which means that the risk of default is slight.

Besides that, many of these countries have built up their foreign currency reserves in a big way so that essentially these are rainy day funds. With GDP growth, obviously it varies, but on balance it’s been reasonably good, particularly in Asia.

We’re seeing an emergence since 1997/1998 of far more political democracies than we had in the past, although I would stress in the last three years or so, there’s been a bit of an erosion there. But nonetheless a majority of people in the world today live in either free or partly free countries and social scientists teach us that there should be some correlation between political freedom on the one hand, and levels of economic development on the other. I don’t want to push that too hard, I don’t know that there’s causality, but there’s some correlation.

Bottom line is: many factors in emerging market countries, in Asia, in Latam, and in Middle East and Central Europe, have seen remarkable improvements. The one important exception I would stress, includes say Sub-Saharan Africa where we’ve seen less improvement overall.

Leo Schulz: Nick, quite a – rosy almost is the word that’s coming to our mind – a positive outlook there. What are your views on the future of emerging markets on a two, three year view?

Nick Eisinger: I think as Jonathan highlights, the fundamentals are much stronger for this cycle than they have been at nearly any other part of the cycle in the past twenty to thirty years. There’s a lot more globalisation; I would say, monetary policy, or central banks across most emerging markets are much more credible than they have been at any time in the past.

Jonathan’s already talked about reserves being built up, the rainy day fund, public financing’s been much more stable, so a lot of these countries have built significant resilience to deal with some of the shocks that inevitably will follow after very strong periods of performance.

But let’s not forget emerging markets are also countries that continue to have a lot of catch-up as far as growth trajectory is concerned. What that means is that as we move ahead over the next two, five and ten years, emerging markets will make up an increasingly large portion of global GDP and that’s already improved, particularly if you include China, over the past ten to fifteen years.

And in many ways, emerging markets are still very under-representative in global capital markets. The numbers off the top of my head are something in the region of a 4:1 ratio, meaning they make up four times as much global GDP as they are representative of global financial indices, both fixed income, and indeed equities.

So I think the secular part continues to be very, very promising; obviously there are some risks in it that perhaps Jonathan and I can address in a moment.

Leo Schulz: So we’re going to come back to some of the opportunities in emerging markets and we’ll look a bit more at the fiscal position, which you’ve both mentioned, but before we come back to that, let’s look at some of the risks.

And I just wonder if, Jonathan, could you start us I think with the trade issue, because this is very much a US, or currently a US/China thing, but there have been some bigger things, TTIP I’m thinking of, and TPP, the big Atlantic and Pacific trade agreements, NAFTA; what’s your feeling around the trade situation?

Jonathan Lemco:  I’d say it’s mixed overall. Those countries in the world, be they developed markets or emerging markets, that have actively engaged in freer trade agreements, tend, generally speaking, to be also the most successful from a macroeconomic point of view.

There’s a broad consensus within the economics community if you will, that trade is, at least trade which is relatively free, is a positive or a good thing.

So it is worrisome, certainly to me anyway, when President Trump almost from the very beginning of his presidency, first announced that the United States would not be joined in TPP agreements with some thirteen other countries all over the world, and then subsequently his rhetoric regarding the NAFTA, which by almost any standard has been a great success, not without problems, but on balance it’s been good for all three countries.

There were some concerns about the US and Korea Free Trade Agreement and very notably, concerns about trade between the United States and China, so this is worrisome, and then you read President Trump’s book, from when he was a property developer: The Art of the Deal, in which he’s very explicit when he talks about property transactions. He says what you do in such a negotiation is you ask for the moon, and you do it in a strident way, almost taking your counterpart aback.

And then over time, when you feel you’re in a high-leverage position, then you backtrack a little bit, then you reach a compromise, but you know that you’ve gone as far as you can in the negotiation.

So when you look at what President Trump’s rhetoric has been in the last few months with regard to international trade, it follows The Art of the Deal precepts very closely. It’s as if he’s trying to equate a property transaction with transactions between countries, and in fact now the rhetoric from the United States government is that maybe the US would join the TPP under certain conditions, we know that.

Leo Schulz: Sorry the TPP, just to be clear, is the Pacific Trade deal.

Jonathan Lemco:  That’s right; the Trans-Pacific-Partnership, that’s exactly right. We know that President Trump is averse, generally speaking, to negotiating with many countries at a time. It’s as if he feels they’re ganging up on him. He much prefers one-on-one or bi-lateral conversations or negotiations.

Nonetheless at the moment, the rhetoric from the White House with regard to the TPP is that under certain conditions maybe the US would enter again. I suspect in large part this is because it’s become clear that with the United States not there, China fills a vacuum and that is unpalatable to US government authorities.

So I don’t know how this plays out, but we have reason to be a little more optimistic today than we were two weeks ago that the United States may become a partner to the existing TPP agreement, but there are important negotiations to go.

The NAFTA, which also had a situation that looked dire two months ago, now looks much more positive. Now admittedly many of the most serious, or concerning aspects of the NAFTA have yet to be successfully addressed, most notably rules of origin, number one, and number two, a dispute resolution mechanism part, which Canada insists on.

However, it does appear now that they’re making meaningful progress on what has already been seven, soon to be eight distinct meetings related to the NAFTA, between Canada, the United States and Mexico, and we may well see a successful conclusion some time in a year or so. You have to get through the Mexican elections which are coming up and which are something of a fly in the ointment to all this, and we can talk about that if you like.

But nonetheless things look more promising there; the US/Korea deal, which appeared problematic for a time and then seemed to be resolved, and then the rhetoric from the White House saying that we’ll delay it because we want to see progress on North Korea. I think we’ll see an agreement here but there’s no question that many of the participants in US/Korea negotiation were concerned to say the least that suddenly you’re taking a trade deal and expanding it to include potential results from a North Korea negotiation.

And finally China, which is extremely important. The US economy and the Chinese economy are complementary in all kinds of ways; they need each other in all kinds of ways; they absolutely do need a much more successful trade relationship, and speaking personally, these tariffs that have been imposed first by the US and then with China matching it, back and forth, are helping nobody.

Leo Schulz: It is interesting, there’s a lot of bluff and bluster, isn’t there in this kind of negotiation? Nick, I wonder if you could explain to us what the impact of policy tightening in the G7 is going to be?

Nick Eisinger: Of course, yes. I mean just as a sort of preamble to this – when you think about risks in any assets, but obviously in emerging markets in this instance, we all clearly need to think very carefully about what’s actually priced in.

So there’s a lot of rhetoric, there are a lot of grand statements that are made, Jonathan’s alluded to some of that, and the market hasn’t really priced any of this in on the downside, partly because I think the market doesn’t believe that the worst-case scenarios are actually going to materialise.

So we’re in a bit of a near-constant situation where you’re in an ongoing process of assessing whether this, if you want to call it a latent risk about trade and tariffs and protectionism, is going to be important from one week to another, or one quarter to the other, but certainly it’s very paramount to think about what’s priced in.

The one thing that I think is going to stay with us for quite some time and will probably remain a more pervasive risk, is the notion of global monetary policy tightening, or the end of QE, if you want to put it in a different way.

Obviously we’ve seen the US move already on that, the Federal Reserve has already raised policy rates six times since the low in its cycle, and there’s plenty of rhetoric as well as reality, of other major central banks following that path less aggressively.

But nonetheless we believe this is the end of this very prolonged period of very, very cheap, very, very loose money, and that means that you do have to reassess your risk/reward equations as you move forward in any asset class.

Emerging markets typically would be the asset class more vulnerable than others to a prolonged and perhaps aggressive tightening in G7 policy rates, but so far the market has taken that in its stride. But we see similar rhetoric coming out of Europe with the ECB again well behind the US in terms of its tightening cycle, but nonetheless we believe that it’s real, you hear the same in the UK.

We’ve seen the Bank of Canada already tighten policy, we also even hear rumblings about the Bank of Japan beginning to step back a little bit.

So if you think about the fundamentals that we talked about a moment ago as having driven a lot of emerging market performance, you also need to bear in mind that very, very cheap, low, global interest rates have been a huge factor in that process.

And naturally, as interest rates go back up again, and the cost of money rises, the cost of getting dollars increases and potentially the dollar goes back up again as well, it does mean that there are some more headwinds against emerging markets.

We’re fortunate that emerging markets are in a much stronger fundamental position this time around, across the board nearly, to deal with these new challenges, and of course it’s not just emerging markets; it’s the same for US investment grade credit; it is the same for a range of other asset classes as well as for equities for that matter.

So we think this is probably a risk that is going to stay with us for a while. It’s going to be something that investors and the market debates on an ongoing basis.

Some of the other risks we’ve put here, if they flare up in an environment where the market is weak and perhaps the monetary policy tightening is upon us more aggressively than we think, some of these other more latent factors can become very serious. So I think we’ve put monetary policy tightening as the kind of key ongoing pervasive risk, and the others probably fit in around that.

I’ll say one or two things quickly on conflict and then maybe Jonathan can finish up on populism. Conflict’s a very hard thing to price, you know, you would have obviously seen it in the news many, many times, and in the headlines.

The issues around North Korea and the potential confrontation between North Korea and the US, that’s very, very hard to price. Actually, what it’s really meant is the market hasn’t priced that, and if you think about the catastrophic binary outcome that is potentially prevalent within that conflict, you can understand why it’s very, very hard to price.

So typically the market looks at brinkmanship, if you want to call it that, in terms of conflict, with some seriousness, but rarely does it price the worst-case scenario, which clearly would be pretty terrible at a financial and certainly a human casualty perspective for North Korea and the US.

Another more recent conflict is obviously what’s been going on in Russia, particularly the escalation in tensions between Russia and the West more generically. And again, Russia comes into this conflict with very, very strong fundamentals; oil prices are higher, Russia’s debt levels are very, very low; its external balances are also very, very solid.

So it comes into it in a position of great strength, which actually means that with the exception of the past week or so when US sanctions really got tightened up, and there has been speculation that they will go further, with the exception of that episode, it has been the right thing to be fairly heavily invested across Russian assets because they have returned some very impressive numbers for you, both in equities and in fixed income.

So these are concepts that we continuously worry about; we struggle I think, as the market generally, to price them in, but you need to be careful about pricing in an Armageddon scenario, because of course it’s very unlikely in the real scheme of the world, that Russia and the US will come to blows militarily.

Again it’s a scenario where if it were to happen, you could say the proverbial all bets are off, but as I say, it’s one that we will revisit and doubtless markets will revisit periodically, and the way we like to think about it is that provided that you’re comfortable with some of the other factors around it, and you’re sufficiently comfortable that you will not get an Armageddon scenario arising from that, you can take advantage of any market weakness associated with these kinds of events, both political and geo-political.

Leo Schulz: As you say, a very difficult thing to price. Jonathan, could I just ask you briefly to touch upon populism and how you see that as affecting emerging markets?

Jonathan Lemco:  I’d be happy to, and just one thing I’d add to Nick’s comment before, is in the past when some emerging market countries encountered economic or political adversity, there was a contagion effect.

Now, as he said, when we’re talking about North Korea and the potential threat it means for South Korea, or alternatively for Venezuela, the market recognises these are one-offs, and as dire as those situations might be, North Korea and Venezuela, they’re unlikely to spread elsewhere, Venezuela just jumps out at you in this regard; everybody knows that it’s problematic.

Now with regard to your question on populism, this has been a theme we’ve been addressing now for two, three years, both in emerging markets, but also in selected developed markets. Obviously the election of Donald Trump was a big part of this in the United States context, where lower middle and middle class people felt that their voices were not adequately heard, felt that maybe their jobs were threatened, whether it by technology or whether by foreigners, and who was elected was a non-politician, a businessman; someone who had a completely different view.

This is not unique to the United States, though. We’re seeing something similar in Italy right now, the Five Star Movement, which is one of the two most prominent parties, according to the polls, in Italy now, and they’re talking about potentially forming a coalition.

Obviously we’ve seen this in the United Kingdom with regard to the Brexit vote; we’ve seen it in the Philippines under Mr Duterte; we’re seeing it potentially in Brazil; we’re seeing it in different parts of both the developed and emerging markets.

And the broad theme here is that although the world is growing at an adequate pace, although quality of life clearly is improving in most countries, there are large swathes of populations that feel they’re not getting an adequate piece of the pie, that their concerns are not being addressed.

And they are turning to extremes, be it to the far left or to the far right in many cases, and I think that’s central to this whole populist emergence.

Bucking the trend in Western Europe of course was Mr Macron in France, but that was unusual relative to other prominent countries in the region and obviously Germany’s a separate case altogether.

Going forward it wouldn’t surprise me if this populist trend continues and more and more populists, usually of the right but sometimes of the left, get elected and therefore policy-making will become less orthodox to say the least. It will become concerning; we may see more anti-free trade policies in many countries; we may see heightened tensions.

We have reason to hope that more and more centrist parties will get elected, but at the moment to me at least, it is concerning that large swathes of the population in many of these countries are seeking alternatives because existing policy-makers are perceived as not fulfilling their needs, that they’ve been lied to.

And more mainstream policy makers are seen as too arrogant and too elitist and all the rest of it, and I think it’s in our interest, as investors, to be paying attention to this.

Leo Schulz: I quite understand and I think the impact on trade is something to watch very carefully, isn’t it? Let’s turn back to some of the more positive factors that are driving emerging markets at the present time.

On the right hand side of the slide we can see sovereign debt to GDP, which both Jonathan and Nick have referred to; a selection of emerging markets on the right hand side, and a selection of developed markets on the left hand side, and I think we don’t need to go into the figures in any detail. I think it’s evident just glancing over them that the figures on the right, in the right hand columns, are in most cases significantly lower than the figures on the left hand side, and that’s just showing the fiscal health, the fiscal strength of many of these leading emerging markets.

Nick, BRICS, Brazil, Russia, India, China and South Africa really kind of drove emerging markets, the marketing of emerging markets, if nothing else, and of course they’re still very big markets and still very important markets for that reason, but there are other markets, which are also coming onto the radar now, aren’t there? I just wondered if you could give us some insight around those.

Nick Eisinger: Yeah, I mean obviously China is critical in its own right as part of the BRICS complex, in terms of its contribution to global GDP, commodities, and very clearly as its contribution pertains to emerging markets in general. If China goes down or slows very, very significantly, the outcome is not going to be particularly pretty for the rest of the emerging markets.

But obviously the global economy will feel that too, so again it’s all relative; it’s about working out what’s priced in under what different scenarios.

So away from maybe some of the more mainstream BRICS, I mean I wouldn’t want to say that Mexico is not a mainstream economy because clearly it is; it’s a very important part of any investor’s portfolio, both from an equity and from a fixed income perspective and both in hard currency and local currency and foreign exchange perspective.

That’s very big market focus for everybody this year, given what Jonathan has outlined about NAFTA and the issues there, and given what’s been outlined about the upcoming July elections, with potentially a small change in policy direction emanating from that.

That said, Mexican fundamentals, the Mexican trajectory, notwithstanding some of these political challenges in the near-term, remain pretty favourable; it’s a pretty developed emerging market economy, if that phrase makes sense, and again will continue to be a very important part of anybody’s investment armoury for many years ahead.

Indonesia, obviously in the Asian region; the Asian region generally being a part of the world that is perhaps a bit more resilient to some of the shocks that come through the global economy, has been a bit of a darling of the market over the past five to seven years, which means that generally speaking assets are pretty expensive there, but you could argue they’re also quite defensive as well, therefore it should be able to absorb a certain amount of macroeconomic pressure, should that arise.

Turkey is going through more of a difficult moment for the time being. Generally speaking, I would say the market sees that as the glass half empty; there’s quite a lot of scepticism in Turkey at the moment, but again this is very much where the art of investing in emerging markets is. It’s establishing what is really priced into Turkish equities or in Turkish fixed income based on the scenarios that we see and that we envisage playing out within the Turkish economy, and more broadly around emerging market sentiment, and global investment sentiment as well.

So just because a country is going through difficulties, or is making some big mistakes, it doesn’t mean that that country is uninvestable; you just have to ensure that when you’re putting your money into something, you’re getting correctly paid for that risk that you’re taking.

So that’s a very important thing to bear in mind whenever we consider emerging markets, particularly given some of the at times frightening headlines that we can see across both the news wires and indeed in the newspapers.

And then just to round up, a couple of perhaps lesser well known markets, Nigeria and Egypt. Nigeria is a big oil exporter; is it kind of the New African lion? I think the jury is still out on that, but certainly there’s been quite a lot of progress made over the past one to two years; it’s becoming an increasingly large focus for more specialised emerging market investors, both hard currency, local currency, and indeed some equities.

And again, if Nigeria were to get some of its act together as it has done in the past two years, it will become an increasingly important part; I’m not going to say it’s going to become a BRIC immediately, but it will become an important element of all of our portfolios.

And then finally Egypt. Egypt has been a pretty phenomenal investment story over the past eighteen months since it entered the IMF programme at the end of 2016. Assets have priced up very significantly, both in fixed income, to a lesser degree equities because the equity market in Egypt is not particularly developed at this stage, but that may well change.

Again, one of the sort of 101 rules when you invest in emerging markets is also to take some caution with the countries that have done very, very well, because a lot of the upside may already be priced into that, and therefore you may already be paying a lot to acquire the assets of the country that has already delivered meaningfully on performance.

So it’s all about what’s priced into the outlook and are you getting paid for what you’re buying into your portfolio?

Leo Schulz: Jonathan, I wonder if I could just ask you, just to round out the discussion with a few words on Brazil just very briefly?

Jonathan Lemco:  Sure. Brazil’s been an adequate performer, but a very big player certainly in the fixed income market, not just the Brazil sovereign, but credits, especially Petrobras and so on.

Brazil has just come through the worst scandal, the so-called Car Wash scandal, in the history of Latin America, in which some very senior political figures, judiciary figures, industrial figures, are in jail, others are in indictment, others discredited, so what you have is a whole new class of leaders in Brazil right now.

From a macroeconomic perspective, Brazil is doing adequately; they’ve got important elections coming up later this year in the fall, and right now your guess is as good as mine as to who emerges. The most popular political figure in Brazil, his nickname or acronym is Lula, he would win if he was allowed to, but the problem is he’s been convicted of corruption and may likely be facing a jail term and as we stand now, he has been forbidden from running for office, although there may still be one appeal left.

So, Brazil matters; it represents half the continent of South America, and as investors we have to be paying attention first of all because of its trade and investment links elsewhere, and secondly because by itself it’s such a very large economy.

There is a fair amount of uncertainty with regard to Brazil at the moment. Polls tell us that the most likely victor is a left of centre, or alternatively a right of centre candidate, but we could still see something much more extreme emerge, so it’s too soon to say.

And just to stress Nick’s point earlier, he hit it right on the head; that if sometimes emerging market countries don’t appear to be doing so well from a macroeconomic point of view, but if you as investors believe that despite the weakness there is attractive relative value – that there’s opportunity here in terms of pricing – then it may well be worthwhile.

It’s always a balance between fundamentals on the one hand and the pricing of a credit on the other, and that’s a judgement call based on experience.

Leo Schulz: Thanks Jonathan, and if I could just ask you again very briefly to finish off the discussion; just what is the proportion of emerging markets that you might expect to see in a well-rounded portfolio?

Jonathan Lemco:  Sure, the Vanguard view is that within any well-diversified portfolio, between 20-40% of the portfolio should be internationally based – the difference being your risk acceptance as investors.

Within that 20-40%, perhaps 25% of that should be emerging markets; it may be debt or it could be equity. So essentially what we’re saying is in most broadly diversified portfolios, somewhere between 5-10%, depending on your risk acceptance, should be emerging market based.

Leo Schulz: That seems a very sensible starting point; some great opportunities in emerging markets and it’s an asset class that can play an important role in a well-rounded portfolio, but investors also need to be aware of the risks.

If you would like to know more about opportunities in emerging markets, please do get in touch with your Vanguard representative, either directly or by calling 0800 917 5508, or write to, and use the same contact details to claim your CPD credits for this webinar.

You can sign up for structured workshops on fixed income and/or how to blend active and passive investments; both workshops are extremely popular. They’re exclusive to advisers, and also bring CPD credits; they are conducted around the country and generally last a couple of hours.

We will be back next month as always on the third Tuesday at 2pm; that’ll be the Tuesday 15 May; our topic will be the Advice Advantage – how do clients benefit from financial advice? We’ll be looking at some of our recent studies from the US as well as research we are currently conducting in the UK, and our guest will be Garrett Harbron from our Investment Strategy Group, a specialist on financial advice.

That’s us for today; thank you to Jonathan and Nick, and thanks to all our listeners, goodbye.

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