June 2017

Emerging markets:
From niche to necessity

Summary

Emerging markets are not the same as they were 10 or 15 years ago. Some countries are ‘graduating’ to developed status (or from frontier to emerging), sector composition is constantly evolving, and new investment approaches (like factor investing) are appearing. The role of EM is evolving. Yet, we believe that both the diversification benefits and return potential are still valid reasons to consider EM assets. In the coming years, EMs could play an increasingly important role both in the global economy – and in investors’ portfolios.

Overview

“Emerging market” (EM) is shorthand for a diverse and heterogeneous group of developing countries that have varied levels of economic development, growth drivers and political risk. To help investors navigate the shifting role of EM assets – from a niche exposure to a core portfolio holding – we offer this guide.

Becoming mainstream

Return and yield potential, diversification benefits, improving fundamentals, and greater accessibility have all played a role in making EM debt and equity core allocations – particularly for cross border institutional investors. This has helped fuel the remarkable growth in EM investing over the last few decades.

Revisiting long-held belief

Despite the growth of EM investing, many investors carry some assumptions about EM assets that may no longer hold. These include: EM risk is singular and static, currency makes EM investing too risky, EM indexes are heavily-tilted to commodities and EM no longer offers diversification. While there are elements of truth to many of these, the story is more nuanced in general. For example, according to our analysis of MSCI indexes, although short-term correlations between EMs and developed markets (DM) have been high, they declined materially over a longer holding period.1 The declining correlations in the longer term appears to have been an effective diversifier of performance DM risk.

Capturing the upside

Figure 1: Risk appetite and EM assets correlation, 2001 to present

Capturing the upside: Risk appetite and EM assets correlation, 2001 to present

Source: BlackRock, Risk and Quantitative Analysis (RQA), as at 7 April 2017. *RTI: BlackRock’s Risk Tolerance Index. RTI measures the overall appetite for risk in the markets by ranking correlation between risk and return for 14 different asset classes. If the risky asset classes are outperforming low risk asset classes, the RTI will be high, and vice versa. By construction, the index can take values between -1 and 1. The period covered by the calculation is from 1/12/2001 to 3/31/2017. EM FX is represented by the JP Morgan Emerging Market Currency Index (EMCI), EM hard currency total return is represented by the total return of the JP Morgan Emerging Market Bond Global Diversified Index, EM equities are represented by the MSCI EM index. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Impending benchmark evolution

EM bond and equity indexes have evolved significantly over the years, but potential changes in the future could dwarf anything seen over the last decade as they may shape the way investors think about investing in EM. Notable potential index inclusions and reclassifications to watch for include the China A-shares addition to the MSCI EM index, Saudi Arabia and China local debt into major EM indices, the possible reclassification of South Korea from EM to DM, and Saudi Arabia’s privatization program. New ways of accessing EM are under way as well: GDP-weighted indexes and factor indexes offer innovative approaches for EM index investors; China may become a standalone asset class in both equities and fixed income.

What to watch out for:

  • Geopolitical shocks (ex: Brazilian President Temer’s corruption charges)
  • Political changes (ex: China 19th party congress, Malaysian elections, etc.)
  • Fed normalization
  • Economic releases in major EM economies


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