1 January 1970

Capturing growth in emerging markets

The strength of markets such as China, Malaysia, India and Brazil tell a powerful story of growth fuelled by demographics, burgeoning infrastructure and a rising middle class. Despite market performance however, perceptions of risk linger and most captive investment portfolios remain almost exclusively invested in US and other developed markets. This must change, according to Peter Marber, chief business strategist for emerging markets with HSBC Global Asset Management in New York. And addressing their potential, Marber makes a strong case for emerging market debt as an attractive way to access stellar growth from within these countries in the decades ahead.

Global economic growth is splitting in two—developed economies are losing momentum, while emerging economies are flourishing. What does this mean for an institutional investor?

The data shows that developing countries are evolving into dominant forces in the global economy and its financial markets. Unfortunately, most investors are significantly underinvested in emerging market equities and fixed income, let alone areas such as real estate and other investment alternatives.

Investors need to integrate these regions into forward-thinking asset allocation models. For the next 30 years, it’s projected that over 70 percent of world growth is going to come from developing countries. These countries already comprise 85 percent of the world’s population and 77 percent of the world’s landmass. They also account for twothirds of global commodity production and a further two-thirds of all hard currency reserves. And yet, right now, emerging markets account for only a quarter of global gross domestic product (GDP), and roughly one-eighth of global stock market capitalisation—and they’ll be much bigger even by 2020.

Why did emerging markets hold up relatively well during the global financial crisis?

The financial crisis in the developed world was rooted in leverage, which was concentrated in advanced markets in Europe and the US. Those countries were the most vulnerable. Meanwhile debt levels— for consumers, corporations and governments—were far lower in emerging markets by comparison. These countries entered the credit crisis with government debt standing at around 40 percent of GDP as opposed to 70 percent in developed countries. This has since ballooned to about 95 percent on average in developed states and is unfortunately still growing because of government deficits in the US, Europe and Japan. Since 2008, debt levels in emerging markets have not changed dramatically.

For decades, emerging markets have been synonymous with risk. Are they too risky for captive investment strategies?

Past evidence shows that a diversified emerging market portfolio can absorb idiosyncratic country risk. When the last major emerging market default happened in 2001 in Argentina, the broad emerging market debt index still posted positive returns without Argentina—an amazing feat since Argentina was more than 20 percent of the index.

As investors, however, we tend to fixate on headlines and crises, but these crises have not really hurt long-term performance. From 1995 to 2010, the emerging market debt index actually outperformed emerging market equities, developed equities, US equities and US bond markets— and that included the Asian, Russian, Brazilian and Argentinean crises. In the end, structural fundamental trends always win out.

You see the biggest opportunity in emerging market debt as opposed to equities—why?

If a country’s sovereign fundamentals are improving (that is, they’re growing quickly, in a balanced fashion without deficits and inflation), then their credit risk premiums should narrow. The risk premium will shrink because these countries are becoming less risky as they strengthen their hard currency reserves and build their human capital and financial capabilities. As a result, their currencies will appreciate against other currencies.

It is global economic convergence—a pattern we have witnessed over the last 100 years. For example, in the late 19th century, Great Britain was the leading economy in the world, with the US quickly catching up. Before World War I, £1 bought $5. With greater productivity and economic momentum, the US narrowed the gap: today £1 only buys you $1.60. The exact same thing happened with Japan. Fifty years ago, the exchange rate was ¥360 to the US dollar—now the US dollar only buys you roughly ¥82. In short, if an economy converges globally, its credit spread narrows and its currency revalues.

And yes, debt captures this structural opportunity better and more directly than equity, with less volatility. Stock markets don’t always capture economic strength—they largely capture the performance of companies listed on an exchange. But in emerging markets, some of the most important companies are often privately held, some are still government-owned and many are joint ventures involving multinationals. Indeed, while China’s economy has been faster growing for 20 years, the Chinese stock market has been a laggard relative to many slower-growing emerging markets.

How can captive insurance companies access these markets?

Interestingly, active management pays better in emerging markets than developed ones. Active management in emerging markets has yielded consistent outperformance according to consultant data. Goodemerging markets managers are a bit like Indiana Jones, constantly scouring markets that might not be on most people’s radar screens and that aren’t being captured by the indexes. The best ones are experienced in studying countries and their trajectories, knowing which ones to avoid and which are investment-worthy. They take advantage of headlines and volatility. The median emerging markets bond manager, for example, has beaten the key emerging markets index by roughly 240 basis points (bps) for the last five years versus flat performance from median managers in the US and global bond universes.

Investors should also consider going into an active pooled vehicle. The administrative and operational burdens of emerging market investing are a headache. Trying to open up currency or custody accounts all over the world is complicated—let professional managers handle it.

What is your outlook for emerging markets debt?

In my opinion, over the next 10 years, we’re likely to see credit spreads grind tighter from current levels and emerging market currencies appreciate structurally against major currencies—so there will be great beta opportunities. And as noted earlier, active managers add value in this space. In my view, that is an excellent combination for any investor.

Peter Marber is chief business strategist for emerging markets at HSBC Global Asset Management (USA) Inc. HSBC’s Bermuda asset management team can be contacted at:

Issued by HSBC Bank Bermuda Limited, 6 Front Street, Hamilton HM 11, Bermuda (“HSBC”), which is licensed to conduct Banking and Investment Business by the Bermuda Monetary Authority. Expressions of opinion are subject to change without notice.

Bermuda increases its exposure to emerging market debt

Bermuda-based companies have been re-examining their allocation to emerging markets within their investment portfolios. There are two main drivers of this reallocation. First, as the emerging market weighting in global indices is mainly based on their current market cap, it does not accurately reflect the effective contribution of the emerging economies to the global economy. Second, as the credit ratings of these emerging economies have been improving, the average credit rating within these economies has been increased to investment grade.

While early institutional investors are reconsidering what the appropriate allocation for emerging markets should be, laggard investors are realising that they are missing a good source of (risk-adjusted) returns, especially considering the current low yields associated with developed market traditional assets.

In Bermuda, this trend, which was initiated by large reinsurance companies increasing their allocation to emerging market debt, is now being followed by captive insurance companies that are including emerging market debt in their portfolios for the first time. As a result of this shift in the allocation paradigm, a significant and steady inflow of investments has been generated and is expected to be maintained in the future.