Emerging markets are inescapable.
Together, these economies account for more than 80% of the world’s population and 43% of global GDP; over the last ten years they have been responsible for some two thirds of international economic growth. Meanwhile public capital markets in these economies have grown to over $50 trillion, compared to around $185 trillion in developed markets.
But while the opportunity set is vast, the total AUM of emerging market-focused hedge funds has contracted to only $250bn. $250bn – according to Hedge Fund Research – pursuing the opportunity set in a $50tn marketplace. The extent of this mismatch creates persistent opportunities for sophisticated hedge funds that do operate in the EM space.
In our view, the EM investment opportunity has transformed from long-biased, value-driven portfolios to a nuanced and agile proposition pursuing positive and negative trends, market neutral carry opportunities, and dislocated value. To understand why the opportunities have shifted so markedly, it is important to understand the profound change in emerging markets over recent decades.
The golden age of Emerging Markets
The fall of the Berlin Wall in 1989 marked a turning point for the developing world. In its wake, a remarkable confluence of positive economic, political and trade factors ushered in an extraordinary period for emerging market countries and assets – a time of unprecedented growth and transformation. This era, lasting roughly until 2015, saw developing economies rise as major players on the global stage and Emerging Market assets enjoy multi-year bull runs.
In economic terms, the leap was driven by the combination of more workers and vastly improving productivity, which combined meaningfully to accelerate EM growth rates.
At the heart of this golden age lay a powerful “demographic dividend.” Between 1989 and 2015 the emerging world’s working age population surged from 2.4bn to 4.0bn. This dramatic growth across emerging giants like China, India, and Latin America provided a vast pool of labour, while also fuelling domestic consumption as these young workers entered their prime earning years.
Complementing the demographic advantage was a global productivity boom. Emerging economies rapidly adopted best practices and technology from developed nations: Eastern Europe nations joined the EU and embraced efficient manufacturing processes; China, South Korea and Taiwan became the world’s factory floor; and India was transformed into its outsourced service centre. This technology transfer, alongside domestic innovation and the movement of workers from agriculture in the countryside to manufacturing and services in cities, saw emerging markets rapidly shrink the productivity gap versus the west. EM productivity grew at over 6% annualised 1989-2015 for the fast track of China, India and Central and Eastern Europe, over 4x the rate of the West.
Beyond immensely positive internal factors, a supportive external environment further fuelled this growth. The newly unrivalled dominance of an optimistic, liberal, capitalist Washington Consensus emphasizing free markets and globalisation fostered an environment conducive to investment, trade and international capital flows. EM was the primary beneficiary of this environment, as a move to reduce trade barriers led to a transfer of IP and the integration of emerging economies into global supply chains; while low interest rates in developed markets drove much-needed capital flows to fund the economic transformation.
The collapse of the Berlin Wall played a pivotal role ensuring the global geopolitical backdrop was just as positive as the macroeconomic one. The “peace dividend” after the dissolution of the Soviet Union ushered in a period of relative stability, allowing emerging markets to focus on internal development without the burden of Cold War anxieties. The US, acting as the global “North Star,” provided a sense of direction and security, encouraging reforms and promoting good governance practices. This fostered an environment where investors perceived lower risks, leading to lower risk premia and increased capital flows to emerging markets.
The results were profound. On IMF figures EM averaged 7-8% annual GDP growth over this period – compared to 2-3% in the developed world. 1.3 billion people were lifted out of property, the greatest single social improvement in the history of humanity, while over a billion joined the global middle class. This paradigm shift fundamentally reshaped the global economic and political landscape.
The consequences for asset markets were also dramatic. For years, EM markets consistently outperformed their DM equivalents – and a generation of Emerging Market managers learned to structure their investment processes around a long bias and a value anchor.
Complexity, dispersion and opportunity in a multipolar world
The last ten years have seen a significant shift in the economic and political landscape of emerging markets compared to the golden age. The general positivity of the post-Cold War era has been replaced with complexity, dispersion, and outright divergence. Not only are there many more EM countries with liquid, tradable asset markets than there were twenty years ago, but now some of these countries have strong economic fundamentals and some weak; some are pursuing positive macroeconomic and political reforms – and some are not. With less uniformity, EM countries now have hugely consequential political and economic cycles that are much less correlated to the rest of the world.
This can be clearly seen in the growth numbers. In aggregate, EM growth has slowed from 7-8% to 4-5%, something of a reversion to the mean after the remarkable years of the golden age, but many countries continue to post stellar numbers. Consider India, whose 8.2% growth last year drove 16% of the global GDP increase alone.
India’s young workforce continues to grow, supporting this growth, with dependency ratios only set to peak in 2040. The same or more can be said for other parts of South-East Asia, the Middle East and Sub-Saharan Africa, but China’s working age population peaked sharply in 2014, while Latin America’s is gently cresting this decade. Further emphasising the complexity, some countries have been highly effective at harnessing these new workers to drive productivity; in others, a lack of jobs for a new generation of young people will risk social stability.
Internationally too, the backdrop is now much more complex under the hood. Perhaps the quintessential political text to capture the geopolitical zeitgeist of the golden era was Francis Fukuyama’s End of History – the idea that liberal, capitalist democracy had vanquished all other political ideals; by contrast, we believe the current era is better characterised by Samuel Huntington’s Clash of Civilisations, originally written as a reply to Fukuyama. The US – and the system it represents – is no longer the undisputed global hegemon: now countries have a variety of governance models from which to choose. The success of China’s state-led development model offers one alternative path, emphasising government investment in strategic sectors, industrial policy, and infrastructure development while deemphasising democracy, liberalism and governance reforms. The Gulf and even Russia offer alternative choices: the former combining much of China’s economic and governance models with a geopolitical willingness to find accommodation with the west, with the latter focused on kleptocratic state capture and antagonism towards the US.
International geopolitics are undoubtedly back as a driver of global economics and asset markets. This is particularly true for low income countries in a world where private financing is increasingly constrained. In the wake of the global financial crisis, the stock of private capital available for emerging markets has been radically reduced by higher capital ratio requirements, smaller bank balance sheets and a move to exchange-based execution. Before Covid, this change was somewhat masked by the impacts of low rates and QE, but no longer. These developments place an increased emphasis on bilateral and multilateral funding, where we increasingly see countries’ geopolitical alignment and geopolitical importance trumping economic fundamentals in dictating access to funding. Countries that are important to or aligned with the West have an easier time securing Paris Club or IMF funding; those more relevant to China or the Gulf can seek their funding from Beijing, Riyadh or the UAE.
Emerging markets are adapting to this new reality with strategies and policy sets that vary as much through time as they do between countries, which pick and choose parts of the various economic models on offer. Some are moving towards orthodoxy in monetary and fiscal policy; others are widening imbalances by shunning it. Elections can drive these changes, but can now also relocate countries across a spectrum spanning from liberal democracy through strongman democracy to autocracy. And while many governments are pursuing nationalisation or increased state involvement in strategic sectors, there are notable counterexamples: Egypt is currently privatising and selling many previously state-owned assets to foreign partners; while Argentina has embarked on a radical libertarian experiment. Finally, shifting global trade patterns are pushing some nations towards greater mercantilism and others to try to shore up domestic demand.
An evolved economic paradigm demands an evolved investment process
Emerging markets countries’ underlying economic and political contexts impact profoundly the structural sources of alpha offered by EM asset markets. In the new paradigm where the opportunity set is bigger than ever before, where countries’ economic and political choices diverge, and where outcomes are highly diffuse, one needs a new set of principles. Adding to this mix, EM investors need to adapt to a market structure in which benchmarked and index funds have overwhelmingly replaced investors with an active mandate.
So what does this mean for an EM investment process? First, that there is still an abundance of structural alpha available: investment processes need to be capable of diversifying across the huge number of tradable EM assets and strategies to maximise investor returns and minimise risk. Secondly, that agility and flexibility are now key: managers need to embrace the positive and negative sides of dispersion and view capital allocations to countries and assets as temporary rather than structural. And thirdly, value is no longer the right anchor for investment decisions: passive money has no consideration for value, meaning assets can stay “rich” or “cheap” for years (consider Indian tech vs. Chinese banks) – but intense passive flows can also create large temporary dislocations that provide rich opportunity.
The framework above is wholly alien from the one that dominated the golden age. It requires of EM-focused managers considerable evolution; yet we believe that for those who have demonstrated such an evolution, EM offers incredible breadth and depth with precious little competition.
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Bradley Wickens is Founder, CIO and CEO at Broad Reach Investment Management
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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group
