The story around investing in emerging markets has been a compelling one, but the reality, as the chart below shows, has been starkly different for investors over the past five years.
During a period marked by recession, a pandemic and higher inflation, the IA Global sector delivered a return more than twice that of the Global Emerging Markets sector.
A traditional period of underperformance for emerging market assets comes when US interest rates rise, this is for two reasons.
The first is that higher US rates increase the returns available on cash and US government bonds, what markets call the risk-free rate, thereby reducing the appeal of riskier assets such as those in emerging markets.
The second reason is that most emerging market companies and countries are able to borrow only in dollar or another developed market currency, rather than their native currency.
A rise in US interest rates usually means the dollar strengthens in value, increasing the debt servicing costs of the emerging market country or company, leaving less capital available for shareholders, bond holders or investments in growth.
Nicholas Field, emerging markets investor at Schroders, says: "The dollar is really the dominant factor when it comes to emerging markets, the question is around extent and of course the reasons why rates have been rising or falling. But for emerging markets to perform well I think dollar weakness is almost a pre-condition."
John Plassard, senior asset specialist at Mirabaud, says: “The fall in US interest rates generally weakens the dollar, making it easier for emerging countries to manage repayments on their dollar-denominated debt, while encouraging investors to turn to high-yielding assets in emerging countries.
"This could boost the currencies of emerging countries and increase investment flows into their bond markets. Central banks in countries such as South Africa and Indonesia have already followed suit by cutting their own rates, which could lead to further economic easing and improved market performance in these regions."
Plassard adds: "Historically, emerging market equities and bonds have benefited from Federal Reserve easing cycles, particularly when the US economy was avoiding recession.
"The change in US monetary policy has also led to a reassessment of the risks in the economies of emerging countries that rely heavily on cross-border trade, which could be vulnerable if the US dollar strengthens or if trade policies change, particularly in the context of the forthcoming US elections.”
Chetan Seghal, who runs the £1.8bn Templeton Emerging Markets investment trust, says that while US rates continue to impact the outlook for emerging markets, his view is that, with India in particular, having developed a pool of domestic investors as its population, becomes more middle class.
Nick Eisinger, principal and co-head of Vanguard emerging markets active fixed income, accepts the above premise, but adds that: “There is no reason why with rates in the US now coming down emerging market assets cannot now benefit, just as they suffered from rates going up.”
