The recovery is further supported by central bank policy, with rate cuts and stimulus packages aimed at supporting growth. We believe this backdrop is sustainable as inflation is expected to be low, so pressure for higher rates will likely be modest.
Moreover, recent US dollar weakness is helping EM companies and countries that have dollar borrowings to access capital markets and repay their debts. Crucially, it eases the pressure on indebted EM governments and allows their central banks to maintain dovish policies. The US Fed’s “lower for longer” interest-rate policy could keep the dollar subdued. A weak dollar supports EM investor risk appetite and is typically associated with strong EM equity and high-yield (HY) bond returns.
Valuations of EM assets are also encouraging. With EM company earnings expected to grow at over 30% next year, their stock prices look particularly cheap versus DM. For example, the price/earnings to growth ratio, which measures a stock’s valuation relative to its growth potential, is just 0.44 in EM—about half the US ratio of 0.82. In EM bond markets, HY credit spreads look very attractive too, near 10-year highs relative to US HY. Wide spreads signal greater opportunity because, when bond spreads narrow, prices rise and generate returns for investors.
In our view, there is further room for EM assets to benefit in the recovery phase. Yet many investors are still on the sidelines, particularly in EM equity. Institutional ownership of EM equities is currently at 7% of overall assets under management (AUM)—as low as it’s been since just before the strong rally in 2017 when the MSCI EM index returned 37%.
Why the reluctance to invest in EM assets? For one, EM investing is generally seen to be relatively risky. It’s true that increased near-term volatility can be expected in the current environment of elevated uncertainty around the pace of global economic recovery, the recent spike in COVID-19 cases in Europe and the transition of administration in the US. But we expect EM to benefit from US reengagement with multilateral institutions like the World Trade Organization under a Biden presidency. Greater trade certainty, which is also likely under a Biden administration, could aid export-oriented EM countries too.
The Power of an Unconstrained Multi-Asset Approach
Investors in single asset classes may miss much of the EM opportunity, in our view. At this pivotal time, investors should position their portfolios to capitalize on developments across the EM spectrum, including in smaller EM countries and companies. By efficiently combining allocations in EM stocks, bonds and currencies, investors gain flexibility to access the wide range of opportunities being signaled by fundamental, valuation and technical measures.
A dynamically managed EM multi-asset portfolio may provide returns comparable to equities, with much lower volatility and shallower drawdowns, in our view. It can also generate attractive levels of income. By looking across the complete spectrum of equity and bond markets, it is possible to select securities in each region that offer appealing risk-adjusted return potential. For instance, we believe Brazilian bonds with a yield of 4% look very attractive relative to highly volatile Brazilian equities, which have a lower earnings yield and look very expensive (Display below).