Domestic issues are now attracting more scrutiny of emerging market managers

Economic reform challenges in China and Brazil have led emerging markets money managers to focus even more than in the past on domestic issues in the countries they're targeting for investment.

“What's happened in previous years can be summarized as the China factor, where one market has been the single driver of an asset class,” said Gerardo Rodriguez, managing director, portfolio manager and head of emerging markets multiasset strategies at BlackRock Inc., New York. “Even with a broad view of the asset class, China was driving the whole thing. Now the story of emerging markets is changing, with multiple factors affecting it. Divergence is now the name of the game.”

Chief among the domestic factors that will affect emerging markets going forward, sources said, are:

• the degree of government interference in a country's economy;

• a market's dependence on commodities as a main economic driver;

• a country's monetary policy; and

• the impact of a strong U.S. dollar on local currency.

Because of the variables that have to be assessed, “it's an ideal environment for an active emerging markets manager,” Mr. Rodriguez added. “It is now an asset class in which domestic drivers are much more relevant than in the past.”

The focus on reform in China as well as in Brazil and Russia has dovetailed with managers now veering away from being heavily dependent on markets whose wealth is centered on commodity exports like oil and gas. Instead, managers are looking closely at the domestic political climate in each market as well as the effect of a strong U.S. dollar and the potential for currency risk.

George Hoguet, managing director and global investment strategist, investment solutions group, State Street Global Advisors, Boston, said the recent sell-off in emerging markets was driven by geopolitical rather than economic concerns. “The sell-off isn't just reflective of the (Federal Reserve) or Chinese risk or Mideast risk. It's reflecting a lack of legitimacy of political leadership, of weak leadership in many emerging markets.”

For some market veterans, that change in focus could be called the “China syndrome,” reflecting their view that the stated goal now of Chinese policymakers — of shifting China's economy from a singular focus on export-led growth to one powered more by domestic consumption — will mark the start of a broader emerging markets trend.

Policymakers beyond China will “have to become more inward looking ... as the mantra that more, stronger global trade” is the key to growth gives way to a greater focus on consumption-led growth, said Anders Faergemann, a London-based managing director and senior sovereign portfolio manager with PineBridge Investments.

The winners over the next five years will be countries “where you can move more to consumption,” Mr. Faergemann said.

That prospect will shine a spotlight on domestic politics, said Dominic Rossi, Fidelity Worldwide Investment's London-based global chief investment officer for equities, at a Sept. 22 market briefing in Singapore.

As long as the export-led model reigned, “the vested interests of the politicians and local oligarchs in some countries, families in other countries ... were perfectly aligned,” Mr. Rossi said.

A world where stimulating domestic consumption becomes a key goal is “much harder for the politicians,” he said, as policies that promote the kind of competition that benefits consumers leave politicians at loggerheads with domestic vested interests.

“From country to country that will play out very differently, depending on how the balance of power between the two really settles,” Mr. Rossi said.

Emerging markets where the prospects of “busting open” local monopolies are poor — such as Russia and Brazil — are the ones where the outlook for reform and growth have declined, while a market like Mexico where, for example, the telecommunications regulator is taking on business magnate Carlos Slim, is doing better, Mr. Rossi said.

“Any sizable emerging markets shop will have to look elsewhere (beyond the traditional, large emerging markets) for opportunities,” said Jeffery Schutes, senior partner, investment business leader, growth markets, Mercer LLC, Atlanta. “Places that will be attractive for investment will be countries in Southeast Asia, which are the most advanced in terms of market development, like Thailand. Other growth areas are in Latin America and Africa. Each of those regions is in a little different situation, but each is attractive.”

Patrick Mange, head of emerging markets strategy, BNP Paribas Investment Partners, London, said that while global investors are still looking to invest in markets based on their weight in the MSCI Emerging Markets index because of those markets' liquidity, domestic indexes also are important to watch.

“Classically, when investing in emerging markets, most (managers) either look at regions or at the entire index,” Mr. Mange said. “Most equity investors would look at long-only benchmarked portfolios but would be concerned about the liquidity of their holdings. You have to be aware of the liquidity risk. If you want to invest, as a global investor, in something liquid, you wouldn't invest outside of the MSCI. ... Every index has its own story, but globally, if you look at the individual country indexes, you can find good opportunities.” He cited Czech Republic, Hong Kong, India, Mexico, Peru, Philippines, Poland and South Korea as markets with good opportunities. “We prefer open markets, where public authorities aren't interfering, as happened in China. But we do expect China to do well in the future.”

The same drilling-down into domestic variables that is being done in emerging markets equity is also happening on the debt side. But Ricardo Adrogue, managing director and head of emerging markets debt, Babson Capital Management LLC, Boston, said the uncertainty surrounding when the U.S. Federal Reserve will raise interest rates has affected emerging markets fixed-income investments.

“Investors have taken a step back,” Mr. Adrogue said. “They're waiting for clarity on U.S. monetary policy and commodity price stability. But investors need to realize that there are different asset classes within emerging markets debt. Hard currency is where there have been good opportunities and return. Corporates and sovereigns (bonds) are in a much better place. The U.S. dollar is the other side of local currency, and with those securities, global investors will want to be paid back in U.S. dollars. That plays to U.S. pension funds, but also with savings institutions in China and elsewhere. ... But investors still need to do their homework. When you invest in these, you need to know why they're issuing debt, how does their debt match their revenue side, and what currency that debt is in.”

Arvind Rajan, managing director, head of global and macro, at Prudential Fixed Income, Newark, N.J., agreed there are opportunities to be had now in emerging markets debt. “But there are two important caveats,” Mr. Rajan said, “be careful what asset class you choose, and be careful what country you choose.”

In hard currency, most emerging markets are not under any default risk, Mr. Rajan said. “In fact, many countries accumulated large excess cushions from commodities in the past — $250 billion in Brazil, $360 billion in Russia, $3.5 trillion in China. Those are very comfortable reserves, enough for them to pay off all their debt at once if they wanted to. Sovereign debt will remain payable. The institutions in these countries are pretty mature, and their macroeconomic policy won't be bungled. In the medium term, they're a good investment.”