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Emerging market (EM) equities are seeing strong inflows as investors respond to developing global trends and rotate capital into the space. We expect this dynamic to continue, which would create an attractive opportunity to get ahead of these flows and to benefit from the strong relative performance we anticipate.
So, why is the smart money piling into emerging markets?
We believe it is principally due to the following trends:
1. The current policy environment
Although quantitative easing has become a common policy tool since the 2008 global financial crisis, the magnitude and scale of security purchases by the Federal Reserve and other global central banks became extraordinary in 2020. More recently, the Fed’s language has shifted to embrace the concept of inflation averaging, which allows for CPI growth to temporarily exceed the targeted 2% rate to offset an episode of slower inflation or deflation.
This represents a material change to the decades-old monetary policy focus on inflation targeting. It is now clear that central banks, led by the U.S. Federal Reserve, are prepared to maintain loose policy for longer, letting inflation run “hot” should we see moderate, sustained upward pressure on prices.
The fiscal policy picture has also become materially bullish in the wake of the Democrat’s surprise wins in the Georgia runoff elections in January. This outcome has handed the party control of the Senate in addition to House of Representatives and the White House. Massive new stimulus along with the additional borrowing necessary to fund it is now all but guaranteed.
While these developments are tailwinds for economic growth, they also drive an expectation for U.S. dollar weakness. EM equities have historically benefited from downward pressure on the U.S. dollar and have been quietly picking up steam more recently.
Looking at the historical relationship between EM equities and the U.S. dollar (see the accompanying graph), apart from the period around the Brexit vote in mid-2016, the dollar demonstrates meaningfully negative correlation to movements in the emerging market index over time. With the expectation for a softer U.S. dollar, investors should be seeking broader international exposure. EM equities are a noted historical beneficiary of this dynamic.
2. Superior Covid management
Although Covid-19 may have originated in Asia, countries in the region have done a better job containing the virus and its economic impact. The following chart illustrates the pandemic’s impact on 2020 GDP growth and forecasts for 2021. EM countries, particularly in Asia, sustained positive growth through last year and are poised to expand the most in 2021.
Indeed, China was the first among major economies to regain its prior peak in economic activity. This is a striking contrast, particularly in consideration of the disconnect in price-to-earnings multiples, which show EM equities remain quite cheaply priced, particularly in China.
3. Diversification
Emerging markets have long provided Canadian investors with diversification benefits. Although the asset class itself can be volatile, the movements tend to differ in timing relative to developed markets. This minimizes the impact of volatility at the portfolio level while being additive to expected return. This is due in part to the different composition of these economies versus their counterparts in developed markets.
For example, while the Canadian economy is concentrated in pro-cyclical sectors such as financials, energy and real estate, EM economies tend to tilt toward the manufacturing and materials sectors. An allocation to EM enables superior portfolio diversification, both geographically and from a sector perspective.
The following chart illustrates changing leadership over time among a collection of international equity benchmarks, and why it pays to incorporate broad global exposure in a well-diversified portfolio.
Graeme Cooper is Vice President of Product at Purpose Investments Inc.
Notes and disclaimer
© 2021 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Thoughtful” page of the Purpose Investments’ website. Used with permission.
All data sourced to Bloomberg unless otherwise noted.
The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained on this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice and neither Purpose Investments Inc. nor is affiliates will be held liable for inaccuracies in the information presented.
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