Emerging Markets Focus

Following the dramatic rise and fall and rise again in emerging market performance over the last few years, investors are understandably interested in the asset class' longer-term prospects. Hugh Hunter, CEO of Blackfriars Asset Management, looks at the positive structural developments in emerging markets that will likely drive performance over the next decade. He argues that long-term investors should continue to include emerging market equities as a core strategic element of their portfolios, but that changing dynamics in emerging markets make a more specialised and thematic approach worth considering.

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Emerging market debt now consists of two asset classes – local currency-denominated bonds and the more traditional U.S.dollar-denominated debt – each containing distinct risk exposures and thus offering distinct sources of return. Investors will be better served by making explicit recognition of local currency bonds as a separate asset class and awarding mandates to managers on that basis – as a result of their own view on how local currency bonds fit in their strategic asset allocation.

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The aftermath of the crash has drawn into sharp focus just how far the emerging markets have come compared with the developed world. If you had no preconceptions, the developed countries today would have the risky image that emerging markets had in the past. In contrast, many emerging would seem to be the epitome of prudence and sound economic management. It is not widely understood that the stimulus provided by emerging markets has been a major factor in reducing the likelihood of another depression.

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In the wake of the financial panic of the past two years, and the market's recent recovery, how should investors view the opportunities in international markets? Kirk Henry and Andrea Clark of The Boston Company Asset Management offer these observations:

Even after the recent upturn, we still see attractive valuations of the kind that typically arise from the indiscriminate selling of high quality companies across the world. Historically, the best performance often has arisen out of protracted bear markets of varying severity.

Much of the world's GDP growth now comes from emerging markets. Though some regions now are as economically challenged, if not more so, than the U.S., many boast healthier banking systems, lower consumer debt, favorable demographics, and interesting valuations.

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The Macroeconomic Team of BNY Mellon ARX – BNY Mellon Asset Management’s Rio de Janeiro-based investment boutique – explores the developments that leave Brazil in a position of relative strength in this difficult environment. Highlights include:

• Brazil’s reforms over the past decade have put the country in a good position to withstand the global economic crisis.
• In the wake of the Real Plan of the 1990’s, the country’s fiscal and monetary reforms have tamed inflation and greatly improved its external account position.
• The commodity boom helped Brazil build a large cushion of foreign exchange reserves, while the economy has diversified through manufacturing and service sector growth.
• Corporate growth will likely be further driven by the country’s burgeoning middle class and the entry of millions of people in the consumer goods markets.
• Brazilian equity valuations are at their lowest levels in a decade, with a number of factors suggesting that the market offers good value opportunities.

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Standish’s Alexander Kozhemiakin, Ph.D., CFA, Director of Emerging Market Strategies, explores a profound shift that has taken place in emerging markets in recent years. Rather than issuing dollar-denominated debt, emerging market countries are increasingly doing such borrowing in their own local currencies. This emerging market local currency-denominated debt (EMLCD) is a relatively new asset class that has only recently begun to attract the attention of institutional investors. In a Q&A format, Alexander addresses some of the most commonly asked questions. Highlights include:

• A decade ago, most emerging market sovereigns had little choice but to issue bonds denominated in dollars. Investors were leery of local currency instruments, whose value could be damaged by hyperinflation and high-profile currency crises. Broad reforms in fiscal, monetary and exchange-rate policies have enhanced emerging market creditworthiness, and fostered strong growth of the EMLCD market.
• EMLCD and traditional emerging market dollar-denominated debt are two very different asset classes. The latter trades at a “spread” over U.S. Treasuries, while EMLCD is comparable to other global sovereign bonds, with their value driven by currency changes and duration.
• Regional and/or country differences have a strong bearing on whether U.S.-denominated bonds or EMLCD predominates. Asia and Eastern Europe (ex Russia), for example, comprise 60% of EMLCD issuance; Latin America represents 46% of dollar-denominated issuances.
• Emerging market exports are less dependent on commodities than is widely believed. Manufactured goods, for example, represent two thirds of the exports of EMLCD issuers.
• EMLCD has held up relatively well during the financial crisis, in large part due to the economic reforms and progress made since the “Asian crisis” of 1998.
• EMLCD is very liquid – trading at spreads generally tighter than U.S. investment grade debt – and well supported by local institutional investors.
• From the perspective of U.S. investors, EMLCD tends to benefit from a weakening dollar.
• High-yielding EMLCD is often used in “carry trades” – borrowing in low-yielding currencies and investing in high-yielding ones. But a number of EMLCD issuers are also favored for other reasons, such as their relative stability during periods of volatility.
• EMLCD offers greater diversification benefits than emerging market equities, especially for portfolios that already have large equity allocations.
• We have a positive view on EMLCD as an asset class that represents some of the higher-rated countries in the emerging markets universe, with the potential to benefit both from currency appreciation and relatively high local bond yields. From the demand side, we see support not only from local country institutions, but also growing acceptance from pension plans in Europe, Asia and the U.S.

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