By Emily Holbrook
Emerging markets are regions that are developing in terms of economic and financial systems. These countries are typically characterized by rapid growth rates, favorable demographic trends, and strong natural resource bases. However, investing in emerging markets is generally considered riskier than investing in developed markets due to factors such as political instability, currency volatility, and liquidity concerns.
It’s important to understand the characteristics of emerging markets and the opportunities and risks they present. Investing in emerging markets requires careful analysis and risk management strategies to capitalize on the regions’ potential growth while minimizing investment risks.
According to Northern Trust Canada, Canadian pension plans returned a median 4.2% for Q1 2023 while the MSCI Emerging Markets Index advanced 3.9% in CAD for the quarter, as information technology and communication services sectors stood out with the strongest performance, while the utilities and health care sectors had the largest declines.
Northern Trust Canada noted that while emerging markets posted positive returns for the quarter, they could not keep pace with developed markets over the period. Even so, Canadian pension plans view EMs as a tool for diversification and hedging amongst its investments now and into the future.
Opportunities Abound?
CPPIB has long been reaping the benefits of investing in emerging markets. In fact, in fiscal year 2023, the organization’s return in emerging markets was 3.3%, an increase of $3 billion to $123 billion, representing 22% of its net assets.
“Investing in emerging markets is part of our overall active management strategy to broadly diversify our portfolio across geographies and asset classes,” said Frank Switzer, managing director of investor relations at CPPIB. “Depending on the country, we invest in real estate, infrastructure, public equities, investment funds and consumer-related industries. Longer-term performance in emerging markets continues to be positive: we generated a five-year annualized net return of 5.4% in emerging market investments.”
PIMCO has also been heavily invested in EMs for some time. As of March 31, 2023, the institution had $45.9 billion assets under management in emerging fixed income strategies. PIMCO not only benefits from a positive ROI in EMs, but also uses the investments as a hedge against credit risk.
“We believe EMs should be seen as a straightforward way to de-concentrate from developed market corporate credit,” said Pramol Dhawan, managing director and portfolio manager – emerging markets, at PIMCO. “A lot of investors treat EMs as a tactical market-timing opportunity, but we think this is wrong. The most effective way to use EM debt in our view is as a structural way to diversify credit risk and do so without giving up yield.”
Emerging Market Risks
PIMCO noted that frontier markets—countries with less established economies than EMs—appear vulnerable, with some countries locked out of capital markets. The sovereign default rate for this subset of EMs is moving higher, with several countries likely to restructure their debt over the next few years. Add to this the fact that an era of quantitative easing by central banks in developed markets is ending, which has been tailwind to borrowing for many of these countries. The investment firm said it’s also important to consider how much more complex restructurings have become given the growing presence of bilateral lenders alongside bondholders such as PIMCO.
“This is one of the reasons why we aim to generate a lot of our returns from the bottom-up, as opposed to directional views on high-risk countries,” said Dhawan. “We are acutely focused on the potential downside, and how to structure for navigating these risks. PIMCO has developed a ‘black hole risk’ framework that aims to identify and avoid extreme, country-specific situations where the first price decline may not signal a buying opportunity but rather a gateway to further declines, creating a gravitational spiral that offers investors no escape. In contrast, there is a rich landscape of new instruments and issuers within countries. Taking such a bottom-up approach has helped us bound macro risk in portfolios.”
Looking Ahead
Dhawan said that, going forward, investors should look at how insurance companies approach investing in EMs. He said such companies take perhaps the most logical view to this asset class, noting that they are naturally incented to look through the mark-to-market volatility and hold for the long-term, to use EM debt as a complement and natural diversifier alongside US or European corporate credit, and to emphasize higher-quality bonds.
“Now is an opportune time to consider investing in EM in our view,” said Dhawan. “Policymakers in developing countries started lifting interest rates sooner and more aggressively than DM peers; we find local-currency bonds have higher return potential relative to an index of dollar debt from the asset class; and the US dollar is still overvalued while developing-world currencies remain cheap in our view.”
Switzer echoed Dhawan’s feelings. He said that, within the next 10 years, emerging markets will represent more than half of global GDP, up from just under 40% today.
“As an investor, we need to capture that growth,” Switzer added.
Emily Holbrook serves as owner and head content creator at Red Label Writing LLC, a content studio that collaborates primarily with the insurance and financial services sectors.
