Emerging markets investing: risks and opportunities

The current context in emerging economies.

In contrast to the developed regions, where economic contraction is expected to be accompanied by a period of disinflation, the macroeconomic backdrop for emerging regions is positive. Expectations point to real GDP growth, low or accelerating inflation and more accommodative central bank policies in some of these regions. In other words, real growth is expected to diverge between the two regions, favouring emerging markets, and this, together with a deflationary environment, is driving investor interest in these regions. Indeed, since the beginning of the year, we have seen an inflow of capital into these emerging regions, as shown in Figure 1, which aggregates capital flows through ETFs by region.

Figure 1. ETF net flows since the beginning of the year (Source: Bloomberg).

However, it is important to distinguish between the different "regional blocs” that exist in the emerging world, as this phenomenon is not common to all regions. These can be divided into:

1. APAC: "Asian and Pacific countries”

2. MENA: "Middle East and North Africa”

3. EME: "Emerging Europe”

4. LATAM: "Latin America”

Each bloc is characterised by factors and risks that are more prevalent in each region. For example, the LATAM bloc has historically been characterised by a high degree of populism, fuelled by an aversion to market liberalisation. In the APAC bloc, on the other hand, after Mao’s death in 1978, Deng Xiaoping initiated a reform programme that mixed communist principles with the liberal policies of the West, dubbed "gaige kaifang” ("reform and opening”). In other words, although China was still considered a communist country, these reforms aimed to combine the cultural principles instilled in the country with greater economic liberalisation. Between 1981 and 1989, China grew at an annual rate of 9.9%, while most countries in the LATAM region struggled with inflation and economic contraction – later referred to as LATAM’s "lost decade”.

Between 1980 and 2000, the LATAM, APAC and EME crises, although different in nature, showed common patterns before they reached their peak. Some of these signs were:

1. Continued increase in the government deficit.

2. Excessive debt (especially foreign debt).

3. Declining volume of foreign exchange reserves, which could make it difficult to fix the exchange rate.

4. Political reforms, in particular social and/or political reforms, which may lead to protectionist measures – restrictions on capital flows, imposition of tariffs on foreign companies and subsidisation of domestic ones – or populist measures – such as excessive government spending contributing to the deficits referred to in point 1.

A detailed analysis of the current conditions in each region is beyond the scope of this article, but the lessons of history serve as a basis for identifying the potential risks of investing in this asset class. However, given the vulnerability of emerging markets to the conflict in Ukraine and the difficulties in the Chinese economy, investors have considered alternatives such as India and the LATAM region, as these regions have shown greater economic resilience than expected. Indeed, as shown in Figure 1, although in absolute terms the inflows (via ETFs) are more pronounced in China, in relative terms (since the beginning of the year) flows have been more pronounced in the LATAM region and in India. Although Turkey also stands out, it has experienced an "outflow” in the last 3 months.

How to invest in emerging markets

Finally, there are additional considerations regarding the investor’s investment style. In other words, exposure to emerging markets can be achieved according to risk profile. Obviously, for the reasons described above, investing in emerging markets is more suited to more aggressive risk profiles.

Firstly, this choice should focus on the type of asset class to which you want to be exposed: bonds or equities. In the case of equities, the investor is able to control the spectrum of risk when making their choice (with the risk increasing in each of the points listed):

1. Companies in developed economies with high exposure to emerging markets.

2. Companies in established emerging markets: up-and-coming regions that have already demonstrated their dominance in the global economy, but have not yet achieved the status of developed economies.

3. Companies in frontier markets: economies with the potential to become the "new emerging markets”, with the expectation that they will achieve high growth rates (close to or above 10%), such as China experienced in the 1980s and 1990s.

In the case of bonds, the investor can choose between sovereign bonds, quasi-sovereign, and corporate bonds. In addition, the investor has to consider the choice between debt denominated in local currency (local currency debt) or in foreign currency (hard currency debt), usually denominated in USD. In other words, a country can finance itself in local currency or in US dollars, which means that the investor can partially cover (or assume) the exchange rate risk associated with the investment.

The important thing to remember is that currency risk is high in these regions, and this applies to both bonds and equities. In this sense, the investor can protect himself against the exchange rate risk by means of currency hedging, but this type of operation is generally not easy for non-professional investors to carry out, due to the limitations of the instruments or the lack of knowledge in this area. However, you can contact Banco Carregosa’s experts to help you with this analysis.

In short, a detailed analysis of this type of investment should take into account macroeconomic issues such as current account sustainability, foreign exchange reserves, debt levels and the degree of externalisation of that debt, expectations of economic growth and inflation, etc. In terms of asset selection, in the case of debt, the analysis should take into account the optimal exposure to duration and credit risk in the regions identified, as well as issuer considerations (particularly when considering corporate debt). In the case of equities, similar characteristics in terms of sustainability, liquidity and opportunism should be taken into account in the selection of companies. The range of factors is broad, making it difficult to analyse each security individually.

Funds specialising in emerging markets

Given the range of factors involved in investing in emerging markets, the alternative is to delegate the task of individually identifying investments in these regions. This is because picking individual companies and/or bonds in inefficient markets with little transparency and information accessibility makes the valuation process very complex. Alternatively, investors can leave these allocation decisions to managers specialising in these regions and concentrate on identifying the factors to which they wish to have exposure. Some of these funds distributed by Banco Carregosa are:

What Banco Carregosa can do for you

As you can see, there is a wide range of choices, which may make some people reluctant to commit to this type of investment. Due to the large number of options available, it is impossible to separate out the different funds in this short article, so they are only presented as examples. These are not investment recommendations, but rather funds from some of the categories defined above, made available by Banco Carregosa. If you are interested in finding out which funds are best suited to your investment objectives, contact our experts for personalised investment information.