Not All Emerging Markets Are Created Equal

Institutional Investor Sponsored Guide to Emerging Markets

Convergence and divergence are contrasting global trends that are shaping today’s investment strategies, according to a new report from CREATE-Research commissioned by Principal Global Investors and the Principal Financial Group®.

One of the key themes of the sixth annual asset management research report, prepared by Professor Amin Rajan of CREATE-Research, is that emerging and developed economies will continue to converge, with higher correlations in terms of investment performance.

On the other hand, the report, “Not All Emerging Markets Are Created Equal,” highlights a growing divergence in investment performance among emerging markets, as some countries address their structural challenges more effectively than others.

“The emerging market story is changing and investors have become more discerning in their strategies, changing the landscape of emerging markets. Investors are increasingly considering emerging markets as a tactical, rather than a buy-and-hold, investment,” says Barb McKenzie, senior executive director and chief operating officer of Principal Global Investors. “Those investors viewing emerging market assets as an opportunistic play have increased from 30 to 48 percent for equities and 15 to 51 percent for bonds, since 2012.”

The 2014 CREATE-Research report draws on the survey responses from 704 pension plans, sovereign wealth funds, pension consultants, asset managers and fund distributors in 30 countries to gain insights into global trends that affect institutional, retail and high-net-worth (HNW) investors.

“This could be the age of stock pickers as emerging markets are no longer considered one homogenous group,” says the report, adding that catchy acronyms such as BRICS (Brazil, Russia, India, China and South Africa) and MINT (Mexico, Indonesia, Nigeria and Turkey) no longer apply to market realities. Nearly 35 percent of survey respondents believe China will deliver strong returns over the next three years, while only 15 percent believe Brazil can do so. Similarly, over 50 percent of respondents believe China will make significant progress in implementing necessary economic reforms, whereas only 6 percent believe that Russia can do so.

Julia Lawler, chief investment officer, the Principal Financial Group Retirement and Investor Services, notes that the report’s findings can help guide sponsors of defined benefit (DB) pension plans as well as sponsors and participants in defined contribution (DC) plans, such as 401(k)s. As she says, “Convergence will not be equal across the developed and emerging countries, creating opportunities for investors at all levels.”

Convergence and divergence

Convergence between East and West will broaden and deepen in two key areas – market structure and investment approaches – over the remainder of this decade, according to the 2014 CREATE-Research report. One reason is that more asset managers from developed countries are expanding their footprints in Asia Pacific and Latin America.

The report noted a stronger correlation between emerging market and developed market equity indices, which now stands at around 0.9.

“The U.S. Federal Reserve’s “tapering” policy will also contribute toward divergence, as it is likely to help the financial markets in developed countries but be a negative headwind in emerging markets,” says Lawler.

“Clearly, there is less diversification benefit than in the past,” says McKenzie, adding that market infrastructures in many Asian, Africa and Latin American countries have been modernized. “We saw a period where all the emerging markets were growing rapidly,” she adds. “Buoyed by strong commodity prices, their currencies gained strength and their economies enjoyed high growth rates. Now investors are being more selective, choosing countries with stronger fundamentals.”

However, the report cautioned that the global economy will not return to sustainable health until both developed and emerging nations take significant action to reduce public debt, strengthen public finances, promote growth and boost competitiveness.

Seeking value opportunities

When considering emerging markets, investors have cycled back and forth between extremes, according to the report. After underestimating the inherent risks in the 1990s, investors overestimated the potential of their economic and population growth in the 2000s. Now, market volatility has led to increased skepticism, with more investors taking an opportunistic approach to emerging market assets.

“We have a long-term positive view on emerging markets,” says McKenzie. “While there is near-term volatility, the demographic and economic changes that are occurring make emerging markets an attractive investment opportunity for investors with a long time horizon and the ability to weather short-term volatility.”

The CREATE-Research report notes that emerging markets will have as many value opportunities for investors as value traps. “The gap between the best and the worst performers will widen,” the report said. “Emerging economies with trade and budget deficits will converge more slowly than those with sound finances”, said the report. “Emerging markets that are back-sliding on reforms are more likely to move more slowly than those seeking a fresh competitive edge.”

Currently, China is the emerging markets leader, with more than 50 percent of investors surveyed indicating they are positive about its near-term economic outlook. “China will look increasingly attractive if its slower growth produces a soft landing,” Lawler says.

In the developed world, the United States remains at the top of the list, as 65 percent of investors believe the government will make significant progress in rebooting the economy over the next three years. “There is no safer bet in the world than the U.S.,” says McKenzie. “One reason is that we don’t face the structural reform needs of other countries around labor laws.”

Investors believe the economic outlook in Europe looks cloudy over the next three years. Growth remains anemic in France and Italy, with stronger performance expected in Scandinavia and the UK.

Within frontier markets, sub-Saharan Africa is expected to deliver the best returns, according to the investor survey. In the Asia Pacific region, Australia, Singapore, South Korea, Malaysia and Taiwan are expected to outshine the others. More investors are looking at Japan, although its entrenched deflationary bias will be hard to change.

Lessons for investors

Investors will respond in different ways to the changing global landscape, according to the CREATE-Research report. DB plans will seek liability-matching assets, while DC plans will focus on capital-enhancing assets. Meanwhile, retail investors will pursue sustainable streams of income, and HNW investors will pursue a range of longer-term goals.

“DB plans around the world face similar issues, including volatility, underfunding and an aging population base. Therefore, they are de-risking and using liability-driven investment strategies. Additionally, they are including assets other than bonds in their portfolios, such as commercial real estate,” Lawler says. “On the other hand, DC plan sponsors are looking for ways to help participants accumulate enough assets to generate sufficient retirement income.”

“Sponsors are focusing on how to increase growth opportunities because their participants haven’t saved enough,” McKenzie says. “They are also worried about inflation risk and are adding real assets to their target-date funds and lifecycle funds.”

“DB investors’ long-term preference for real assets is evidenced by a notable increase in investor appetite for real estate over the last two years, growing from 40 percent to 66 percent,” says McKenzie.

Retail investors will become more cautious as they approach retirement, while many HNW investors take a longer-term perspective that includes taking on liquidity risk while also seeking capital growth and asset protection. “In a low-rate environment, investors need to put some careful thought into how to generate income,” Lawler says. “That tends to generate greater interest in foreign investment.”

As institutional, retail and HNW investors look at fresh strategies for emerging and developing markets in the next few years, new products will be created to provide exposure to broader investment opportunities, according to McKenzie and Lawler. As McKenzie says, “Convergence and divergence are long-term structural trends that will continue to create value opportunities for global investors.”

Principal Global Investors is the institutional asset management arm of the Principal Financial Group®. Comprised of a network of specialized investment boutiques and teams, it manages assets on behalf of public and private pension funds, foundations and endowments, central banks, insurance companies, sub-advisory arrangements and sovereign wealth funds. The multi-boutique firm offers a single point of access to world-class investment boutiques and expertise in fixed income, equity, and real estate investments as well as currency management, asset allocation, stable value management, and other structured investment strategies. For more information please contact: 1-800-533-1390 or principalglobal.com.

The Principal Financial Group® (The Principal®)1 is a global investment management leader offering retirement services, insurance solutions and asset management. The Principal offers businesses, individuals and institutional clients a wide range of financial products and services, including retirement, asset management and insurance through its diverse family of financial services companies. Founded in 1879 and a member of the FORTUNE 500®, the Principal Financial Group has $517.9 billion in assets under management2 and serves some 19.4 million customers worldwide from offices in Asia, Australia, Europe, Latin America and the United States. Principal Financial Group, Inc. is traded on the New York Stock Exchange under the ticker symbol PFG. For more information, visit www.principal.com.

1 “The Principal Financial Group” and “The Principal” are registered service marks of Principal Financial Services, Inc. Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Financial Services Inc. and Principal Life are members of the Principal Financial Group® (The Principal®), Des Moines, IA 50392.

2 As of June 30, 2014.