Commentary: Emerging markets are now masters of their own fate

MSCI's decision to include Chinese A shares in its emerging market benchmark equity index is a watershed moment.

To be sure, this move is helping to expand the investible universe and is a step in the right direction toward making the index more reflective of the emerging markets' true economic potential. Yet, as investors evaluate the implications for their portfolios and the best ways to capitalize on this development, they would be wise to reflect on their approach to emerging market investing more broadly, understanding the best investment opportunities will be driven more by the structural forces shaping emerging markets today than by changes to the indexes. Even with this announcement by MSCI, passive strategies will be insufficient in the new economic order. A bottom-up approach that focuses on the cross-cutting themes, sectors and companies that drive investment returns in emerging markets will be required.

Coined in 1981, the term "emerging markets" was meant to capture the dynamism of a third world that hitherto had conjured images of drought-ridden farmlands, knock-off electronics and Soviet-era machinery. For several decades, sensible market reforms, trade liberalization in the West and export-led growth helped emerging markets fulfill this economic promise. That era is over.

For a start, aging populations have structurally constrained the long-term growth potential of developed markets to well under 2%, stifling demand for exports from emerging markets. In parallel, rising emerging market wages and increasing automation are beginning to shift some manufacturing sectors back to developed markets, especially as Western firms weigh the sociopolitical advantages of a homemade product.

On top of that, growing income and job polarization in the United States and Europe has led the middle classes of developed countries to stage a populist backlash against globalization and free trade. It is striking that while income inequality between countries around the world has steadily declined since the 1980s, inequality within individual developed economies has actually increased over the same period, leaving developed market workers feeling disempowered, vulnerable and at the losing end of globalization. The resulting protectionist sentiments are threatening to unravel a global trade regime that significantly benefited emerging markets.

In short, the rising developed market tide that lifted all emerging market boats is rapidly receding. Increasingly, emerging markets are masters of their own fate, with their individual abilities to capture domestic and regional opportunities determining their future growth paths. But if emerging markets can no longer ride on the coattails of developed market growth, global trade liberalization or Chinese supply chains, will they still have a role to play in driving global growth?

The answer is unequivocally yes. As developed market economies slow down, retreat and offer savers increasingly lower yields, emerging markets will be the primary drivers of global growth over the next decade. They already represent nearly 60% of global gross domestic product on a purchasing power parity basis and are forecast to contribute over 90% of global middle-class spending growth between now and 2030.

What's more, emerging markets will increasingly propel their own economic success, with three key engines of growth.

First, emerging markets will increasingly look to other emerging markets for new and expanded trade links. Trade among emerging markets is already on the rise, at 40% of their global exports in 2015 from 25% in 1995. Going forward, emerging markets will have opportunities to tap into China's growing consumer market and link into India's new supply chains. Perhaps most notably, emerging markets will have the opportunity to promote trade links via China's New Silk Road — that will culminate in new highways, railways, energy grids and port facilities connecting 65 countries in Asia, Africa and Europe.

Second, successful emerging markets will convert disruptive digital technologies into opportunities. Companies in the developing world already are using the digital revolution to leapfrog inadequate bricks-and-mortar institutions, meaning e-commerce and mobile payments are at times significantly more pervasive than in developed markets. Indeed, emerging markets that put in place the right incentives and intellectual property protection might also be able to speed up the famously slow process of technology transfer from developed markets: new technologies can now be transferred instantaneously via code rather than the time- and resource-intensive process of foreign direct investment and local "learning by doing." Successful emerging markets also will likely draw on their diasporas to accelerate this process of technological learning. Ultimately, competing successfully will require investing in physical capacity, such as high-speed broadband and cellphone towers; regulatory reform to encourage digital entrepreneurship; and an education program that creates a digitally savvy workforce.

Third, the future of emerging markets will increasingly be shaped by their ability to meet the domestic consumption needs of their expanding middle classes — who are increasingly urban, aspirational, connected and wealthy. Research by the McKinsey Global Institute suggests that by 2030, the consumption of emerging market middle classes will rise to more than $30 trillion — about three times the current consumption levels in the U.S. — and reshape the global consumer map. Increasingly, consumption will shift toward consumer discretionary, financial services, health care, recreation and travel. In 2016, for example, the number of outbound Chinese travelers reached 135 million, representing more people than the populations of the United Kingdom and France combined.

These radical shifts in the forces shaping emerging market growth will require investors wanting to participate in the emerging market growth story to take a very different approach than what worked in the past. They will have to position their portfolios for emerging market divergence: a one-size-fits-all classification of emerging markets will only mislead.

Investors will also have to internalize that many emerging markets are now significantly more resilient: from 2007 to 2011 well below 10% of emerging markets underwent a systemic banking crisis, compared to nearly 50% of developed markets, according to the International Monetary Fund. As a result, long-term investors will be able to take advantage of the fact that the market perception of emerging market risk lags the reality on the ground of improving macroeconomic strength and declining contagion risk.

Finally, investors must rethink the use of indexed investment strategies, which lock investors into inherent structural limitations of the indexes and by definition miss out on the best investment opportunities. For example, emerging market fixed-income indexes are weighted toward the most indebted countries and are unable to generate the significant returns available through thoughtful rotation across countries, credit and currencies. Emerging market equity indexes, for their part, are heavily skewed toward large financial services, energy and mining, and big state-owned companies. Thus, they don't fully capture the next wave of domestically driven growth opportunities best represented by midcap, small-cap and private companies. Of note, China's A shares are heavily weighted toward financials and industrials, sectors considered to be part of China's "old economy."

The key point is this: Emerging markets will successfully shape their own destiny and place on the global economic landscape, in a manner increasingly resilient to the political upheavals and economic slowdown in developed markets. In this new order, investors must look beyond the market beta of the broad emerging market universe to harvest idiosyncratic alpha from specific themes, sectors and securities across all emerging market asset classes.

David Hunt is president and CEO, and Taimur Hyat is chief strategy officer, at PGIM. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.