Allocating to Emerging Markets? Consider These Factors.
Regional exposure varies
Emerging markets investing looks different depending on whether you invest in equities or fixed income. If you invest in an equity product benchmarked to a broad market index, such as the MSCI EM, you can end up with a very chunky unintended exposure to a small group of countries as shown in Figure 1. The top five countries in the MSCI EM make up approximately 80% of the index, with China representing roughly a quarter. The picture changes substantially in bonds.
Figure 1 – Composition of Emerging Markets Indexes
MSCI EM | 2/29/2024 | EMLC | 2/29/2024 | EMB | 3/8/2024 | ||
---|---|---|---|---|---|---|---|
China | 25.8% | China | 9.8% | Saudi Arabia | 6.0% | ||
India | 17.6% | Indonesia | 9.0% | Mexico | 5.9% | ||
Taiwan | 16.7% | Malaysia | 7.8% | Indonesia | 5.0% | ||
South Korea | 12.5% | Brazil | 7.8% | Turkey | 5.0% | ||
Brazil | 5.5% | Thailand | 7.2% | UAE | 4.4% | ||
Other | 21.9% | Other | 58.4% | Other | 73.6% |
Source: Natixis Investment Managers Solutions, MSCI, JP Morgan
In emerging markets government bonds, there are two broad flavors, represented here by two ETFs.- EMLC – Tracks the JPM GBI-EM Global Core Index and represents sovereign local currency issuers.
- EMB – Tracks the JPM EMBI Global Core Index and represents sovereign USD bond issuers.
Pay attention to currency risk
When investing in emerging markets, you’re taking on currency risk. This currency risk differs meaningfully across equities and fixed income. Looking at currency risk within the EM debt space, investors commonly make the decision to allocate to either of the two broad flavors we referenced above.
While EMB doesn’t have direct currency exposure, it’s fair to say that the credit risk of these bonds is affected by fluctuations in their currency. If the USD strengthens, relative to an EM currency, debt servicing costs increase in terms of the local currency. EMLC, on the other hand, has direct currency exposure as these sovereign bonds are denominated in local EM currency. The currency translation effect is reflected in a US-based investor’s return.
This currency translation effect is reflected in a US-based investor’s return for emerging markets equities as well, and the impact can be substantial. You can see this impact on returns in Figure 2, where we show performance for MSCI EM USD (returns for a USD-based investor), vs. MSCI EM LCL (returns for a local currency investor) for periods when the dollar price index (DXY) is rising and falling.
Figure 2 – The Impact of Currency Translation
USD Price Index (3/29/2019–3/22/2024)
Source: FactSet
Caution: Credit quality may vary
It’s also worth noting that within the bond space, there is a meaningful difference in credit quality, depending on the broad flavor of EM sovereign debt you choose. Emerging markets’ local currency issuers are widely recognized as higher quality than their USD-issuer counterparts for two reasons:
- Local currency issuance is safer for the issuer, since falling currency, relative to USD, does not negatively affect the issuer’s ability to repay principal and coupon in their own currency.
- There is enough demand for currency of the issuer, implying a stronger economy and ability to service debt.
Figure 3 – Credit quality comparison
EMLC | EMB | |
---|---|---|
As of date: | 1/31/2024 | 1/31/2024 |
AAA | 6% | 0% |
AA | 5% | 8% |
A | 21% | 17% |
BBB | 35% | 29% |
Total IG | 67% | 53% |
BB | 16% | 22% |
B | 1% | 18% |
CCC and below | 0% | 6% |
Unrated | 16% | 0% |
Total below IG and unrated | 33% | 47% |
Source: Natixis Investment Managers Solutions
What about the diversification benefits?We’ll finish up by highlighting the potential diversification benefits of allocating to a combination of emerging markets equity and debt in a portfolio. Let’s assume an investor, who is constructive on both EM equity and debt is considering the following changes to a 60/40 portfolio. Portfolio holdings are proxied using benchmarks. The proposed changes include adding 5% to MSCI EM and 5% to JPMorgan EMBI Global Diversified, sourcing from the S&P 500® Index and Bloomberg US Corporate BB, respectively (Figure 4).
Figure 4 – Adding EM equity and debt allocations
Weights | ||
---|---|---|
Portfolio Holdings | Current | Proposed |
Equity | ||
S&P 500® | 60% | 55% |
MSCI EM | 0% | 5% |
Fixed Income | ||
Bloomberg US Aggregate | 30% | 30% |
Bloomberg US Corporate BB | 10% | 5% |
JP Morgan EMBI Global Diversified | 0% | 5% |
Total | 100% | 100% |
Evaluating the risks
We prove out this point by analyzing roughly 13 years of returns for the S&P 500® and MSCI EM indexes, and credit spreads for the Bloomberg US Corporate BB and JPMorgan EMBI Global Diversified indexes. We use credit spread data for fixed income to neutralize the duration impact to return. The regression between the time series indicates whether two asset classes have a propensity to outperform/underperform at the same time:
- Time series 1: Excess return of MSCI EM vs. S&P 500® Index –> Positive value = EM equity outperformance
- Time series 2: Excess spread change of JPMorgan EMBI Global Diversified vs. Bloomberg US Corporate BB –> Positive value = EM debt outperformance
Figure 5 – EM equity and debt historical performance relationship
EMD/BB vs. EM Equity/S&P 500 (1/31/11–3/29/24)
Source: Natixis Investment Managers Solutions, FactSet
The views and opinions (as of April 8, 2024) are those of the author(s) and not Natixis Investment Managers or any of its affiliates. This discussion is for educational purposes and should not be considered investment advice. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.
Although Natixis Investment Managers believes the information provided in this material to be reliable, including that from third party sources, it does not guarantee the accuracy, adequacy, or completeness of such information.
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Natixis Advisors, LLC provides advisory services through its division Natixis Investment Managers Solutions which are affiliates of Natixis Investment Managers, LLC.
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