In Part One of our emerging markets blog series, we take a look at trends affecting emerging market economies and where we see opportunity.
The Global Financial Crisis forcibly aligned emerging market macroeconomic and monetary policy cycles. But, as we move further from the trough, emerging markets are becoming increasingly less homogeneous. Divergence in macro cycles along with low correlations in emerging market equities increases the importance of selectivity.
This is a key point that we continue to highlight in the emerging markets space. With growth and investment performance across countries varying between markets, emerging market equities cannot be bought and sold indiscriminately. Rather, country dynamics must be taken into account, as opportunities are far from uniform. These characteristics support a hybrid investment strategy in emerging markets.
Stock level returns in emerging markets are more affected by top-down, country-specific factors relative to developed market stocks. Emerging markets lack the extremely broad, deep, and sophisticated financial sectors found in many developed economies. This results in currencies that tend to experience greater levels of volatility and capital flows that have an outsized effect on the investment environment.
Political risk is greater, inflation rates are more varied, and the idiosyncratic characteristics related to demographics as well as population and income growth rates all represent attributes that increase the importance of incorporating top-down macroeconomic analysis when targeting emerging market equities.
Further supporting this hybrid approach is Citigroup's Global Risk Attribute Model (OTC:GRAM). Applied to the MSCI Emerging Markets Index and the MSCI World Index, the model quantifies the relative importance of top-down analysis in the emerging markets space. It determines portfolio sensitivities to key macroeconomic variables such as bond yields, commodity prices, credit spreads, currency rates, and investment style factors.
We plotted the percent of total variance explained by the local market terms of the model. The results clearly show that country-specific factors have an outsized effect on emerging market equity returns relative to developed markets, currently and on a historical basis.
Manning & Napier has more than 20 years of experience investing in emerging market equities through the Manning & Napier Fund, Inc. International Series. The Series contains meaningful exposure to emerging markets, with approximately one-third of its assets allocated to the space. The Series' exposure is driven by a top-down analytical framework complemented by bottom-up security analysis to determine what positions are best suited for the portfolio.
Due to significant differentiation among emerging country fundamentals, which we expect to lead to performance dispersion, our approach focuses on specific pockets of opportunity rather than the emerging markets asset class as a whole. This strategy is supportive of high active share and broad capitalization coverage.
Within the Series' emerging markets allocation, our flexible, opportunistic, and unconstrained investment process seeks to capitalize on the growth of an emerging consumer class, driven by strong secular tailwinds due to demographic makeup and favorable growth dynamics. Top-down macroeconomic analysis assists in identifying the emerging markets that offer the best long-run growth opportunities. A portfolio construction process driven by top-down inputs allows us to pinpoint the country/sector pairs that provide the longest runway for growth and are best supported by the strongest underlying macro fundamentals.