Emerging Markets Ripen For Multi-Asset Investors

| About: iShares MSCI (EEM)

By Morgan Harting, Daniel J. Loewy

Solid returns in equities and debt have reignited interest in emerging markets this year. As the recovery unfolds, searching across stock and bond markets can help investors regain confidence to return to the developing world.

Emerging markets have posted a stellar year so far. In equities, the MSCI Emerging Markets Index has advanced by 12.2% through August 2, outperforming developed world equities. In fixed income, the JP Morgan EMBIG Index has risen by 12.5% over the same period. And with the outlook for growth and income improving, we believe active managers who cast a broad net across asset classes can gain better access to the return potential of emerging markets.

Earnings Growth: The Tide Is Turning

Emerging markets stocks have underperformed their developed market peers over the last five years, weighed down by a slowdown of economic growth in China, lower commodity prices and stagnant global trade.

That's finally changing. In 2016, EM earnings are expected to grow by more than 6%, compared to flat growth in developed markets. As those improving earnings begin to get recognized by investors, we see an increasing likelihood of sustained positive returns. And beyond the earnings advantage, a solid dividend yield of 3%, along with a potential for multiple expansion, could provide significant tailwinds.

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Income: Pronounced Yield Advantage

Investors can generate income in two ways: through bond coupons or stock dividends. Given the extremely low yields offered by developed market government bonds, and the compression of yields in the high-yield markets, select emerging market bonds now offer compelling advantages. Historically, emerging markets government bonds have yielded less than US investment-grade and high yield credit, but today they yield meaningfully more. Credit spreads for high yield EM are now 1.4% higher than US High Yield, and the spread on investment-grade EM debt is now 0.4% more than that on US BBB corporates.

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Likewise, equity investors seeking yield can find high dividend payers in emerging markets at reasonable valuations, while their developed equivalents now command steep prices. The MSCI EM High Dividend Yield Index yields 5.6% and trades at 9 times earnings, a discount to the standard EM index. By contrast, stocks in MSCI's index of developed market high-dividend stocks yield only 3.9% and trade at 17.8 times earnings.

Staying Active: Exploiting Inefficient Markets

Active managers have continued to deliver results in emerging markets. That's because markets in the developing world are still burdened by inefficiencies that stock pickers can exploit.

For example, stocks are generally less widely covered and information flows more slowly, providing research-based active managers with more of an edge. What's more, the relevant benchmarks are poorly constructed and hardly representative of the fast growth and dynamic companies investors think they're getting when they buy emerging securities. More than three-quarters of the MSCI Emerging Markets Index's market capitalization outside China is in countries growing slower than the average across the developing world. And within China, more than half of the market cap is in state-owned companies.

Similarly, the standard emerging bond index is hardly appealing; more than 22% of its yield spread comes from four C-rated credits (Venezuela, Ukraine, Mozambique and Belize). In our view, this reflects a high degree of concentration in the riskiest issuers that many investors may not be aware of.

These inefficiencies can be especially useful for managers who look across asset classes. Instead of investing in equities and bonds as distinct markets, managed against two separate benchmarks, an integrated multi-asset approach with a single objective provides more levers to improve risk-adjusted returns.

Brazilian Local Government Bonds Look Attractive

For example, Brazilian local government bonds yield 12% today. In the current's environment, we think that's a very attractive equity-like return, which comes with far lower volatility than Brazilian stocks.

By contrast, local rates in Korea of 1.4% make bonds quite unattractive from a return perspective. On the other hand, capital costs are extremely low for companies there, setting a low hurdle for profitability in order for the average stock to be attractive.

Simply bolting together an index-sensitive EM equity and EM debt portfolio would fail to capture these mispricings, leaving lots of opportunities to generate higher returns at lower risk on the table for managers with a holistic approach.

Emerging markets always present complex challenges for investors. By making active trade-offs between equity, debt and currencies, we believe the dynamic emerging market landscape can be effectively navigated to get the most from a potential long-term recovery.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.