With the peak of inflation likely behind us, and China reopening its economy earlier than expected, emerging markets are back on investors’ radar. Yet the global scenario remains complex and ‘emerging markets’ encapsulates a fragmented and diverse collection of countries, meaning investors have several options to consider. With changes afoot, we believe now is the time to reassess your exposure to emerging markets.
The performance of emerging market (EM) equities was mixed last year, held back by the underperformance of Chinese equities and tighter liquidity conditions. Looking ahead to where they go next, two main factors are likely to play an important role: the US dollar, and China.
A strong dollar tends to accentuate the period of correction when EM economic activity declines. It also often leads to tighter credit conditions (due to these countries’ USD financing) and higher inflation.
On the flip side, when economic activity in EM trends upwards, local currencies strengthen, leading to better economic performance. The chart below shows that EM equities tend to outperform developed market (DM) equities when the US dollar is weaker. With the dollar having fallen in recent months, despite its recent rebound the stage could be set for an EM equity revival.
Source: Bloomberg, Amundi. Data as at 10/02/2023. Past performance is not a reliable indicator of future performance.
Long-term tailwinds for EM
Aside from short-term factors, EM economies are highly likely to benefit from long-term tailwinds, such as strong demographics and urbanisation, which should accelerate growth in the region in the years ahead.
Economic activity in the region has been suppressed over the past few years by repetitive lockdown measures across Asia, the Russia-Ukraine war in Europe, and tighter liquidity conditions resulting from the Fed and the ECB’s aggressive tightening. Yet there is much more growth potential in EM economies than other more mature economies.
In our view, barring a major global recession, emerging economies are likely to enter a period of economic recovery – led by China.
According to Bloomberg calculations, China is expected to account for roughly 60% of MSCI EM’s revenue growth for 2023, while South Korea, EMEA and India should make a positive contribution to sales growth1. China’s re-opening should also favour South East Asia, particularly tourism-dependent countries that will likely benefit from the lifting of a travel ban. The Chinese recovery is likely to be bumpy, however, with bouts of volatility in the near term. Be prepared for political tension between China and the US to spill over sporadically into equity markets.
The final area of advantage for EM equities compared to developed markets is their heavy discount. In spite of the recent re-pricing, these are at the lowest levels seen for the past twenty years.
Source: Bloomberg, Amundi. Data as at 10/02/2023. Past performance is not a reliable indicator of future performance.
EM equities’ attractive valuations, coupled with their better earnings prospects, should support performance, particularly for countries with strong balance sheets which are less dependent on USD funding issues.
Foreign flows into EM equities have also proved supportive. These have been piling up since early November 2022, with over $50bn of net new assets accumulated, of which almost half ($24bn) flooded into the market in January this year. This comes in stark contrast to the -$28bn of net outflows observed from March to late October 2022. China, Korea and Brazil equities have been favoured markets over recent months1.
Adding a sustainable dimension to EM equities
There are several ways to approach EM equities. A broad strategy captures the full diverse range, while another separates the titan of China into its own allocation.
Still another approach is to integrate some sustainability factors into an EM allocation. After all, emerging markets companies’ reliance on foreign capital for growth is pushing an increasing number to improve working standards and sustainability, and increase their focus on stakeholder value.
When looking at a broad allocation to EM equities, integrating a Net Zero strategy reduces overall carbon intensity and improves the exposure’s ESG score. The table below shows the limited tracking error between an ESG CTB equity index compared to an unfiltered investment universe. The ESG CTB filtering allows for a 40%+ reduction in the portfolio’s carbon intensity and an improvement of its ESG score.
Combining an SRI-filtered implementation of an EM exposure with alignment to the requirements for EU Paris Aligned Benchmarks leads to an improvement of the ESG score and a reduction in carbon intensity. However, it will also result in a higher tracking error with the parent index. Having said that, it demonstrated meaningful benefits in last year’s challenging market context, as shown below.
Source: Bloomberg, MSCI, Amundi. Data as at 30/01/2023. Past performance is not a reliable indicator of future performance.
1. Source: Bloomberg, National Sources, Bloomberg, IIF, Amundi. Data as at 30/01/2023. Past performance is not a reliable indicator of future performance.
Knowing your risk
It is important for potential investors to evaluate the risks described below and in the fund’s Key Investor Document (“KID”) or Key Investor Information Document (“KIID”) for UK investors and prospectus available on our website www.amundietf.com.
CAPITAL AT RISK - ETFs are tracking instruments. Their risk profile is similar to a direct investment in the underlying index. Investors’ capital is fully at risk and investors may not get back the amount originally invested.
UNDERLYING RISK - The underlying index of an ETF may be complex and volatile. For example, ETFs exposed to Emerging Markets carry a greater risk of potential loss than investment in Developed Markets as they are exposed to a wide range of unpredictable Emerging Market risks.
REPLICATION RISK - The fund’s objectives might not be reached due to unexpected events on the underlying markets which will impact the index calculation and the efficient fund replication.
COUNTERPARTY RISK - Investors are exposed to risks resulting from the use of an OTC swap (over-the-counter) or securities lending with the respective counterparty(-ies). Counterparty(-ies) are credit institution(s) whose name(s) can be found on the fund’s website amundietf.com. In line with the UCITS guidelines, the exposure to the counterparty cannot exceed 10% of the total assets of the fund.
CURRENCY RISK – An ETF may be exposed to currency risk if the ETF is denominated in a currency different to that of the underlying index securities it is tracking. This means that exchange rate fluctuations could have a negative or positive effect on returns.
LIQUIDITY RISK – There is a risk associated with the markets to which the ETF is exposed. The price and the value of investments are linked to the liquidity risk of the underlying index components. Investments can go up or down. In addition, on the secondary market liquidity is provided by registered market makers on the respective stock exchange where the ETF is listed. On exchange, liquidity may be limited as a result of a suspension in the underlying market represented by the underlying index tracked by the ETF; a failure in the systems of one of the relevant stock exchanges, or other market-maker systems; or an abnormal trading situation or event.
VOLATILITY RISK – The ETF is exposed to changes in the volatility patterns of the underlying index relevant markets. The ETF value can change rapidly and unpredictably, and potentially move in a large magnitude, up or down.
CONCENTRATION RISK – Thematic ETFs select stocks or bonds for their portfolio from the original benchmark index. Where selection rules are extensive, it can lead to a more concentrated portfolio where risk is spread over fewer stocks than the original benchmark.
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