In focus

Are fundamentals turning more positive for emerging market assets?


The last decade has been challenging for emerging markets (EM), to say the least. EM equities 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.

Read the full paper here

On top of that, 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.

However, amidst of all this uncertainty, we believe there might be some unexpected opportunities for EM 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.

An unexpected opportunity in the pandemic

The key reason why a number of EM countries have struggled over the last decade can be traced to the inability to accumulate sufficient savings, as we explain in the paper. Countries such as Brazil, South Africa and Mexico have had savings rates far below than what is necessary to fund investments in the economy.

The lack of savings in these countries has resulted in structurally low growth, high inflation and increasing levels of government debt. In order to plug the gap between savings and investments, the countries have had to run current account deficits, making them reliant on foreign capital inflows. But as the sentiment towards EM soured in the middle of last decade, the inflows dried up, leading to persistent weakness in EM currencies.

With EM government spending increasing sharply in the pandemic, it would seem that savings have fallen further. However, a silver lining is that private savings, in most cases, have increased by even more than government deficits. This is the case because EM current accounts, reflecting the aggregate balance between savings and investments, have improved significantly since the beginning of the pandemic. In fact in 2020, almost all major EM economies registered current account surpluses.

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Granted, some of this improvement is likely to reverse once the restrictions are eased and normal economic activity resumes. But the increase in private savings has been a longer-term trend in many countries, and was well underway before Covid-19.

It could be that after years of saving too little, the private sector has started to adjust in EM, with the disruption caused by the pandemic providing further impetus. A permanently higher private sector savings rate would be a long-term positive for growth, since it would allow more investments and eventually, higher growth.

While it is too early to tell if this will really be the case, the first result of the shift in savings has been that the new government bond issuance in EM has been funded almost exclusively by domestic investors, rather than foreigners. This could go a long way in helping to at least put an end to the precipitous currency weakness that has weighed on EM assets over the last decade.

A new commodities super cycle?

The second fundamental driver that has turned more positive for EM in the Covid-19 pandemic is commodity prices. The Bloomberg Spot Commodity Index, a broad commodity index, has increased by 72% since March 2020, standing at its highest level since 2011. How likely it is that commodity prices will continue to move higher?  

There are good reasons to believe that this could be the beginning of a new commodities super-cycle. Most importantly, investment in new supply has been limited over the last decade, as low prices have deterred producers from taking on new projects.

At the same time, the demand for commodities, especially those associated with global energy transition, is likely to increase substantially over the next decade. Given this supply and demand mismatch, prices might have to increase for supply and demand to reach equilibrium.

Higher commodity prices are crucial for many EM countries that have struggled over the last decade, especially in Latin America.

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The tailwind of global trade growth

Despite the significant impact of the Covid-19 pandemic on the global economy, global trade has weathered the storm surprisingly well. Global export volumes, after dropping sharply in the early stages of the pandemic, have rebounded and are now well above the pre-pandemic level. Clearly, the unprecedented fiscal stimulus measures in many countries have boosted demand for various goods.

Since a number of EM countries are heavily dependent on exports, global trade growth is a critical factor. In fact, the latest data show that the exports of countries such as Mexico or South Africa have recovered fast, even as the local economies remain well below the pre-Covid levels.

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EM have faced some significant headwinds over the last decade. However, with the increase in private savings, higher commodity prices and strong global trade growth, EM fundamentals are perhaps in better shape than many feared at the onset of the global pandemic.

While their long-term growth prospects remain subdued due to years of insufficient investment, improving fundamentals could at least put a stop to the precipitous currency weakness that has weighed on EM assets. The big question is whether these improvements can be sustained.

For investors, the changes brought by the Covid-19 pandemic could at least warrant a fresh look at EM. Some of the structural headwinds, while perhaps not abated, have at least lessened.