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Have Emerging Markets Emerged?

By Rayna Penelova 

Let’s face it, emerging market investments are not for the faint of heart. They behave more like the roller coasters of global equity markets, contrasting the lower volatility of the developed world.

For example, the S&P has done well this year and we continue hitting all-time highs with a 17.6% year-to-date return. However, emerging markets have been the real star of the show this year with a 33.5% return YTD (in USD). In 2015, however, the story was different. The S&P 500 produced a mediocre return of 1.4% for the year, while emerging markets cratered 14.9% (Source: Bloomberg)

Over the past year, the global economy strengthened and Emerging Markets have performed well.  At the same time, the dollar weakened. This provides a double benefit to U.S.-based EM investors.  The lower dollar also provides relief to countries with higher dollar denominated debt, which benefit from lower repayment costs measured in their home currency.  With the dollar declining so quickly over the past year, many investors are becoming concerned about its possible rebound and how that would affect emerging markets in the near future. Nobody wants a repeat of the 1997 Asian debt crisis, which saw debt-to-GDP ratios jumping from 100% of GDP to 167% in the four large Association of Southeast Asia Nations.

However, conditions today are quite different. The external debt for emerging markets has indeed been climbing, however, so has GDP levels in the EM space; up from about 2 trillion dollars in 2007 to more than $6 trillion today. As a result, the external debt-to-GDP ratio is sitting near the long-term average, slightly above 22%. In addition, emerging markets’ foreign exchange reserves have nearly doubled in the same time. In the event that the dollar suddenly rises, emerging markets will be more prepared and should be able to mitigate this headwind by spending some of their foreign exchange reserves. (Source: Bloomberg, IMF-April 2017)

EM FX Reserves

Source: Bloomberg

Not only are emerging markets becoming more developed in their capital structure, they are also becoming more internally focused. One of the characteristics of developed economies is the strong middle class and the economic resilience that stems from it. If exports are a smaller part of the economy, then the economy becomes less susceptible to external shocks from currency fluctuations or demand troubles abroad. Therefore, it is noteworthy that India and China are projected to be the fastest growing middle classes in the world over the next 30 years. This means that consumer-focused products, and the services industries in those countries, should grow at a fast pace.

Global Middle Class

Source: https://www.oecd.org/dev/44457738.pdf

OECD Development Centre Working Paper No.285

The emerging consumer is a compelling long-term growth theme. A long-term growth trend like this is the exactly the type of catalyst we look for when making investment decisions.

This, coupled with the stronger relative position of EM economies, leads me to believe emerging markets should continue to outperform in the years to come.  As emerging markets emerge, the way investors look at the EM space will need to evolve, which could provide additional support to the investment thesis.

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