A diversified emerging market strategy may offer attractive return potential.
Most emerging market (EM) economies struggled in 2021 as slow vaccine deployment and the spread of the Delta variant tempered their recovery. Risks remain, but we see potential for a rebound—particularly if, as we expect, higher interest rates cause developed-market GDP to revert to trend.
We think EM economies may be poised for stronger growth in 2022, particularly those at earlier stages of reopening. As DM countries start to withdraw aggressive monetary and fiscal stimulus and EM growth picks up, we expect the growth gap between the two, currently at its narrowest point in at least 20 years, to widen.
An active EM equity strategy may have the potential to outperform a US one over the next decade as EM populations grow and innovation expands. Equity valuations are attractive on a relative basis (Exhibit 12) and earnings growth is running at a decade-high. The region is home to some of the world's best-performing companies (Exhibit 13), though many may not be captured in standard benchmarks, which overweight state-owned enterprises and volatile export-driven industries. An active approach can help investors increase exposure to companies benefitting from secular growth trends.
Exhibit 12: Current Price to Book (P/B) Levels are near 20 year lows vs the US
Source: Bloomberg, FactSet, DataStream, Goldman Sachs Asset Management. As of December 31, 2021.
Exhibit 13: EM is home to some of the best-performing companies
Source: Bloomberg and Goldman Sachs Asset Management. As of November 30, 2021.
Treating China separately may help create more efficient EM equity portfolios. China's weight in the MSCI EM Index has doubled over the past five years and could exceed 40% five years from now. An EM ex-China equity strategy offers sector and macroeconomic diversification; for example, EM ex-China names tilt toward semiconductors and tech hardware while China leans toward the consumer retail and internet sectors. This can affect performance; the MSCI EM ex-China Index outperformed the MSCI China Index by 32 percentage points in 2021.
The income potential of EM debt may help to enhance the stability of portfolio returns in a challenging investment environment. EM debt has offered attractive nominal and real yields relative to comparable DM debt. Country selection remains important, as economic and political risks vary. Some assets may struggle if inflation causes the Fed to reduce asset purchases and raise rates more rapidly than expected. But improved EM current account balances mean many EM countries are better prepared to withstand modest capital flight than they were in the past.
EM ex-China
Those with a long time horizon might consider coupling an EM ex-China equity allocation with a China all-shares strategy (onshore A-shares plus offshore shares) to seek to capture the full opportunity set in both markets. This can provide diversification benefits while potentially enhancing alpha opportunities. An EM ex-China allocation, for example, offers deeper access to smaller EM countries and potential alpha opportunities in small-and mid-cap stocks. It can also allow investors to tilt toward or away from China depending on prevailing market conditions. And carving out China exposure gives investors more control over the size of their allocation to the country.
Emerging Market Debt
Dedicated exposure to EM corporate bonds may help boost income potential and strengthen portfolio return stability. They may also make sense for investors looking to enhance their DM credit allocations. Selective exposure to high-income strategies that are less reliant on price appreciation may be a good way to bolster return potential. We see compelling potential opportunities in Asia high-yield bonds, which have delivered strong risk-adjusted return relative to comparable DM assets and have lower interest-rate duration. Strong economic fundaments in the region may temper default risk.