Changing perceptions of risk in emerging markets

A few decades ago, the differences between developed and developing economies were clearly delineated. Developed markets were known for stable governments, conservative monetary policy and lower levels of debt, while emerging markets were perceived as being much more risky with regard to politics and central bank policies, and had high and often unsustainable levels of borrowing. In today’s world, though, these distinctions have often become much less clear. While emerging nations have worked to develop their institutions and policies, and in many cases have gotten their debt levels under control, developed markets have found themselves at a turning point, marked by political and economic uncertainty.

While economic growth for emerging nations has slowed down somewhat in recent years, it is still impressive when compared to the sluggish pace of developed markets. As shown below, the International Monetary Fund forecasts that gross domestic product (GDP) growth for emerging markets will significantly outpace the developed world for the foreseeable future.

Economic growth for emerging markets is expected to expand, while developed markets’ growth remains stagnant

Source: IMF, World Economic Outlook, October 2016. Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially. For illustrative purposes only.

Emerging-markets equity: For an active manager investing only in companies where there is high conviction, the focus is on company fundamentals rather than expectations for the broader global economy. And fundamentals such as corporate profitability have been improving. Net income margins for non-financial companies in emerging markets surpassed those of their counterparts in the developed world last year, and return on equity (ROE), another measure of profitability, exceeds that of European and Japanese companies.

Net income has begun to rebound for emerging markets

Source: UBS GEM Inc estimates, April 2017.

Emerging-markets debt: Similar to emerging-market equities, flows into emerging-markets debt have been robust so far this year as investors search for attractive yields. A majority of these investors are located in developed markets. While valuations have risen, there is still some value to be had in these securities if investors are selective. Furthermore, many of these bonds have investment-grade ratings even when they may offer relatively higher yields than similarly rated bonds in developed markets.

 

Yields and ratings for debt issued in emerging markets vs. developed markets

Source: S&P Local Currency Debt Rating, Bloomberg, January 3, 2017.

1. Bloomberg consensus forecasts are used for 2017 CPI (consumer price inflation)

2. Standard & Poor’s credit ratings are expressed as letter grades that range from 'AAA' to 'D' to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.

For illustrative purposes only.

 

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).