Are fundamentals turning more positive for emerging market assets?

The impact of the Covid-19 pandemic in many of the more vulnerable developing countries has been shocking. Vaccines are supporting the outlook for a transition out of the crisis, but the prospects for a straight line recovery are slim and the path will vary greatly by economy.

The macroeconomic impact has also been profound, and has exacerbated existing frailties in a number of emerging markets. However, amidst of all this uncertainty, we believe there might be some unexpected opportunities for these economies to emerge stronger from the pandemic. For investors, these developments perhaps warrant a fresh assessment of the challenges and opportunities that emerging markets offer.

As we show, many of the long term headwinds have, at least for now, lessened. Private savings have increased during the pandemic, global trade is rebounding and commodity prices have picked up. The question is whether these improvements are sustainable. Issues such as low-savings rates and weak public finances remain unresolved in some economies and further reforms are needed.

The last decade has been challenging for emerging markets (EM), to say the least. EM equites have persistently underperformed developed market (DM) equities, giving up most of the outperformance of the early 2000s. On the debt side, EM local currency government bonds have delivered close to zero total return for international investors since 2011.

Granted, depreciating EM currencies have played a big part in shaping these returns. For example, since June 2011, Brazil’s equity market has appreciated 158% in local currency terms but has lost 20% in US dollars1. The same applies for EM local currency bonds, which have seen strong returns cancelled out by the losses on the currency side.

The upside of this disappointing performance is that valuations of EM assets have improved. Consequently, investors are wondering whether the tide is finally turning for EM, or if the relative cheapness is just a mirage. In order to answer this question, we need to first understand the drivers behind the lacklustre EM performance, and whether any of the headwinds are showing signs of dissipating.