Emerging Markets 2.0: New Investment Mindset Required

By: Amer Bisat, Managing Director, Head of Emerging Markets Fixed Income & Karen Leiton, Director, Emerging Markets Specialist on the Fundamental Fixed Income team

Executive summary
• Over the past 40 years, Emerging Markets (EM) have gone through a dizzying up and down. After being lauded as the new investment frontier, the asset class lost steam sometime after the Great Financial Crisis.
• We believe the loss of market momentum very much reflected a marked downshift in EM’s growth prospects. That, in turn, mirrored the plateauing of Chinese growth, de-globalization trends, rising EM indebtedness, and, like the advanced world, a sharp escalation in political polarization and volatility.
• The change in EM’s landscape does not mean the asset class is not attractive. EM still offers significant opportunities and value propositions. What it does mean is that EM 2.0 requires an entirely different investment mindset.
• Investing in EM 2.0 necessitates laser focus on differentiation, diversification, income as a source of potential return and a preference for quality. To successfully navigate the asset class, the investment process must rely on deep and rigorous investment research, employ the various asset allocation levers available to them, and, crucially, have sophisticated risk measurement and management tools.

Over the prior 40 years, or so, the Emerging Markets (EM) have witnessed multiple ups and downs. After starting as a “land of promise,” the asset class lost steam sometime after the Great Financial Crisis. In this commentary, we trace that journey. We argue that EM remains an eminently investable and interesting asset class, but that the rules of the game have radically changed. We are now of the view that a new mindset is needed when investing in EM. We think the old days of investing in EM as a simplistic raw beta play are behind us. To successfully navigate the world of EM 2.0, investors must focus on differentiation, diversification, income, quality, disciplined risk management and rigorous research.

What Changed for EM Economies in the Wake of the Global Financial Crisis?
In our view, EM’s disappointing performance is primarily explained by the sharp growth downshift experienced after the Great Financial Crisis. In turn, that slowdown reflected multiple and interrelated factors including a less powerful China pull; the difficulty EM experienced in replacing external growth sources with internal ones; the broad deglobalization trend; rising indebtedness; and the worsening political backdrop. Below, we delve into those dynamics in more detail.

Growth Slowdown
The key factor that changed in 2010 was that EM’s growth boom ran out of steam. At its peak, EM was growing at an almost 8% pace, but by the time the Covid pandemic hit in 2020 the pace had fallen to just over 3%. Where growth is concerned, compounding matters: at an 8% annual growth rate, an economy doubles roughly every 8 years but at a 3% rate of growth, the doubling occurs every 23 years. Moreover, and as we show, the deceleration was not concentrated in just one or two areas but cut across all EM regions.

What Are the Investment Implications of EM 2.0?
This paper has traced the changed economic and fundamental backdrop facing EM, noting that markets have already become aware of these changes and have steadily repriced the asset class. The question then becomes, do those changes require a different approach to investing in the asset class? Our view is that the answer is a resounding “yes.” Below we spell out some of the implications of this new EM investing paradigm:

• Not all EM is the same. We do not think EM assets should be seen as a generic bet on a broad “EM promise.” As a result, we do not think EM should be invested in as a “raw beta” play. Selectivity and differentiation are key elements for the new EM investment mindset. In fact, our analysis shows that dispersion in EM asset price changes has already risen. We believe this trend will persist.
• In EM debt, carry is powerful. Historically, investors tended to see EM as a “re-pricing” play. That approach made sense when the “EM promise” was in its ascendency and the asset class was steadily re-pricing stronger. As we discussed above, though, we believe those days are behind us. Instead, what we think is most compelling in our portfolios is to focus on monetizing the EM discount, which we define as the excess yield EM may offer over its DM comparators.
• Rigorous research is necessary for EM 2.0. EM is no longer a simplistic unidimensional thematic asset class. Indeed, the new EM paradigm we discussed throughout this paper requires numerous asset allocation and bottoms-up security selection decisions. Our view is that a well-staffed and deep research bench with access to data, systems and analytics is a necessary tool for effectively managing EM portfolios.

Conclusion
It is our contention that EM, as an asset class, has radically changed over the past two decades, and as a result, requires a novel investing approach. We think the days where one invested in EM as a “raw beta” play are gone. We believe differentiation, diversification, disciplined risk frameworks, rigorous research and solution-based investments are the hallmarks of successfully navigating the world of EM 2.0.

Please download the full report here: BlackRock Emerging Markets 2.0