Deteriorating rule of law; too much debt; too much inflation; fractured, divided, divisive and ineffectual politics; poor governance; lack of credible institutions or institutional frameworks; low liquidity; and excess volatility.

This is a list of the sort of justifications one might hear if one asked why emerging markets are categorised as emerging and not developed. But hands up who thought I was listing problems with the US or UK? I would definitely have my hand up if someone else had written this list and I was reading it.

This speaks to something ephemeral about the distinction between ‘emerging’ and ‘emerged’. Some of the factors which seem to go into this judgement are very much structural. These structural factors don’t change quickly or easily – in either direction – and thus it is these that we should lean on most heavily when assessing the categorisation of a given market or economy. Inflation and fiscal policy can change with the economic and political winds, but things like credible, functioning and independent central banks and judiciaries rarely appear or disappear overnight. This doesn’t mean that changes in these structural elements cannot occur and indeed there is no defined boundary, nor even an agreed metric, to measure these factors. South Korea has to all the world the appearance of a highly developed and wealthy economy with manufacturers, exporters and technology companies that are globally competitive and significant. Yet South Korea is still considered an emerging market. Maybe that sounds crazy to many, but does it sound less crazy just months after the sitting president invoked martial law, seemingly for tenuous and political reasons, resulting in his arrest and removal from office?

Questioning EM/DM distinction is nothing new

There is no right answer here. As long as I have been working in asset management, there have been folk openly questioning the distinction between emerging markets (EM) and developed markets (DM). During that time, there have been many cheerleaders from the EM community robustly touting the improving quality and return-enhancing characteristics of the emerging world. In the aftermath of the global financial crisis (GFC) in 2008, this noise became deafening. Of course, what many of us believed before, and we all know now, is that much of that economic success in the EM world was built on the back of China’s investment and construction largesse and the insatiable demand for commodities it created. As that sugar high receded, so did the returns on many EM investments.

In many cases, the spoils of this massive one-off injection were wasted. Further sentiment damage has been done by a series of high-profile defaults in the emerging world – with the countries in question including previous poster children for successful reform, such as Ghana. Today the EM asset class has felt under owned and unloved for a number of years.

The weakening US dollar

Last month I wrote about the US dollar and its potential decline, not on the basis of it being superseded as the world’s reserve currency, but rather on the basis that ownership of US dollars, particularly via ownership of unhedged US assets, had become extreme and unhealthily imbalanced. As that imbalance corrects, we anticipate global investors will seek greater diversification in their currency exposure, along with some asset diversification too.

A decline in the dollar will have a number of effects – most of them very well advertised. These include the depression of local currency returns from ownership of US assets, inflationary impacts in the US due to higher import prices and the boosting of US dollar-denominated revenue and earnings from global operations for US-based firms. Some good, some bad, most well understood.

Interesting opportunities in the EM world

As global fixed income investors seeking value in a cyclical context, wherever we might find it, we at Marlborough believe that some of the more interesting and lucrative opportunities that a falling dollar might present are within the emerging world.

Even before the dollar began to fall, it was increasingly clear that, post-COVID, policy making and politics in the developed world were becoming increasingly EM-like. For most of the period since 2008, developed market central banks have been neutering price signals from bond markets and, in doing so, they have allowed governments, and thus citizens, to worry less and less about the pitfalls of fiscal profligacy or even excess debt in general.  

The UK bond market has come closest to exerting discipline in recent years by quickly dispensing with the ill-timed, ill-thought-through and terribly communicated policies of former Prime Minister Liz Truss. Even then, the Bank of England felt compelled to buy gilts in the open market at the same time it was hiking rates and selling bonds to deal with the inflationary effects of combined monetary and fiscal bazookerism – an incredible demonstration of cognitive dissonance even by the standards of modern technocrats. These lessons have been quickly forgotten as the current government increasingly gives the impression that the threat from markets is hollow and certainly not important enough to derail the cabinet’s need to signal their virtue using other people’s money.

Governments spending like 'drunken sailors'

The UK is not alone. Governments from Tokyo to Tirana are spending like drunken sailors, despite uncomfortably high inflation, relatively high yields and very high deficits.

Comparatively, there is some restraint evident across the emerging world. You would be hard pressed to find a budget surplus, but the degradation of deficits is less pronounced and in most cases the stock of debt as a proportion of the economy is much, much lower than the 100% or so which now seems to be the norm in the developed world.

This is the EM/DM convergence I have been hearing about for years (usually from someone with an EM product to sell, it must be said)... though I rarely recall anyone proposing a convergence led by the decline of DM as opposed to the emergence of the previously emerging.

This convergence has been, to a significant degree, true for a few years now. I used to have a slide in my old pitchbook showing the US budget deficit as a percentage of GDP through the COVID years plotted against the same statistic for Mexico. Looking at the Mexican line one would be forgiven for asking what all the fuss was about – it hardly budged. The US deficit made an assault on 20% of GDP – nearly double where it reached because of the GFC and the near total bailout of the financial system which was required at that time. As a context that is terrifying – particularly for anyone who lived and worked through that period.

In isolation, however, this notion didn’t generate much additional interest in emerging markets. With the UK, US and other DMs suffering incredible economic, political and market volatility I guess most folk just had bigger fish to fry.

Biggest reason for increased interest in EMs

We believe that’s now changing and we think the biggest reason is actually the shifting view of the fortunes of the US dollar (clearly, it’s not because calm and tranquillity have descended on developed markets).

The dollar is crucial for everyone but its particularly crucial for the fortunes of the emerging world. As a group, these nations tend to export a lot of commodities (which are priced and mostly traded in US dollars) and they tend to borrow a lot in US dollars. Prima facie, it is cheaper for them to borrow in US dollars, because investors will demand higher yields to lend to a country with the high inflation experienced perennially by most EM countries. This means that a weaker dollar makes debt servicing cheaper, but it also means lower domestic revenue from commodity sales (all else being equal, of course). Of potentially greater significance, however, is the direct effect on monetary policy of a stronger domestic currency.

In previous US Federal Reserve monetary easing cycles, EM central banks were often reluctant to ease monetary policy too far or too fast. This was because once the Fed was cutting this was often the time when risk assets performed badly and the dollar was very strong. If EM central banks cut rates too swiftly that could cause capital outflows, currency depreciation and imported inflation, all of which could further weaken their currency. This was a dangerous doom loop only too familiar to emerging market economies and policy makers. However, we can now envisage a scenario where the dollar continues to decline due to shifting global portfolio flows. And, most pertinently, this decline could resist the usual flight-to-quality rally which tends to drive the dollar higher in times of risk aversion. Such an environment would allow EM central banks with low and/or falling inflation and very high real rates to ease monetary policy more significantly, without weakening their currencies.

This would mean positive returns from both duration (bond prices rising as interest rates and yields fall); currency exposure as EM currencies outperform the dollar and benefit from inward portfolio flows; and the ‘carry trade’ – as investors take advantage of many of these economies continuing to have interest rates higher than those in the major developed economies. That is a heady and potentially lucrative mix for investors willing to understand the specific issues and dynamics of some of these yet-to-emerge markets.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.