Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
2022 Emerging Markets Mid-Year Outlook: Navigating Opportunities and Headwinds
Despite the -16.3 per cent year-to-date (YTD) performance, we are impressed with the resilience of emerging market (EM) equities. In any year with the S&P down 19.9 per cent, the US Dollar (USD) up 7.2 per cent, Russian assets marked to zero, and China locking down its two largest cities, one would rightly cover their eyes before looking at EM performance. Impressively, though, EM has outperformed various asset classes this year due to (1) prudent central bank policies, (2) higher commodity prices, and (3) recognition of the disconnect between EM and developed market (DM) valuations.
EM equities remain significantly under-owned. The MSCI ACWI+FM benchmark has an 11.7 per cent allocation to EM, but global equity investors still carry only 4.9 per cent exposure. This underweight positioning combined with discounted valuations, higher growth rates, and higher dividends sets up an interesting catch-up opportunity. Now we need a catalyst.
Chinese equities fell 21.6 per cent in 2021, as measured by the MSCI China Index. The majority of this slowdown was self-inflicted, and we believe the pendulum has swung too far. While the rest of the world is tightening monetary policy and easing fiscal stimulus, China is the only major central bank in the world cutting interest rates. The Chinese government is also extending credit, picking up spending, and reducing regulatory rhetoric. This is creating a significant amount of pent-up demand and the coil has continued to tighten as China pushes its zero-Covid policy. The question regarding a rebound is not if, but when.
At some point, China will likely fully reopen based on a combination of successful new vaccines, testing measures, and the eventual move to endemic status. At this time, the combination of rebounding demand from China and global commodity supply restrictions could create a significant opportunity for EM assets. We continue to focus on finding dynamic companies with quality management teams and unique business models that can offer sustainable returns well above their cost of capital.
