This is a sponsored article from Pioneer Investments.
“Inefficiencies at the sovereign and corporate level have resulted in investors demanding a higher risk premium from Emerging Markets.”
Unearthing the Potential of Emerging Markets
The potential of Emerging Markets (EM) has been somewhat reduced to a more volatile and less appealing field of choice for investors, mainly due to implementation shortfalls such as regulatory weakness, legacy capital structures and policy failures. These shortfalls collectively contribute to investor requirement for a higher risk premium that, consequently, can inhibit market diversification and constrain capital flows.
However in recent years, the asset management industry has begun to recognise weak governance as an opportunity, helped substantially by accommodative monetary policy. In fixed income, superior governance standards have generally correlated with smoother performance. We have seen less default risk in those issuers with higher quality governance, while in equities an active portfolio of well-governed companies have outperformed a portfolio of less well-run operations.
The potential is immense. According to the IMF, the emerging world has contributed 80% of global economic growth since the 2008 financial crisis; today, they account for more than 60% of global GDP. It is estimated that by 2050, the GDP of the seven leading EM countries will be more than double that of the current G7 .
Factors driving Emerging Market returns
We believe that three factors collectively drive EM returns – economic growth, market deepening and changes to governance. Growth and market deepening are straightforward and propelled by secular drivers, but governance is more complex. To commit capital, investors require legal protection of their interests; the concept of ownership needs to be consistent with the Western definition of the term.
It is our view that the largest single contributor to investor dissatisfaction in EM stems from variable standards of corporate and sovereign governance. In fixed income, not every issuer who can pay chooses to do so, while in equities the issue of “transparency” in accounting is problematic in some markets.
A critical question for the EM investor
The question for investors is not whether EM sovereign management is generally improving but whether EM economies are getting sustainably better fast enough to compete successfully in the future. This means developing competitive advantages against both emerging and mature countries alike. Bulls typically point to the recent record and argue that the last decade reflects a growing EM renaissance. The more bearish view is that there is still much to do and that the required resources and time to deployment are not generously distributed. More pernicious are those voices that point to the widening gap between rich and poor in the emerging world.
Looking towards Progress
While positive demographics and open economies have supported growth, the reality remains that EM countries are riskier than mature countries. EMs are engaged in a struggle to attract investment and generate prosperity. Competitive advantages can be narrow, policymaking can be surprising and thus outcomes unexpected. Negative investor experiences have accumulated over time and can reflect in a higher risk premium.
To attract investment, countries need to offer investors stable economies, guided by predictable policymaking, while local laws need to offer a stable, consistent framework for competition. It is common to claim that many countries have made progress in these areas, but not all have.
Some EMs have made strong progress around sovereign governance in recent years. In many places, room remains for a quickening in the pace of development. More so than ever, governments need to deliver improved prosperity to alleviate conditions conducive to unrest.
The important role that EM plays
The economic and social benefits of improved governance practices in the developing world could lead to a period of growth that pays a wide range of dividends. For mature market savers, an increase in economic activity by the 700 million people who live on a dollar a day in the developing world could create the demand that leads to a more balanced global economy. An improvement in governance could attract capital to corporates that are focusing on reducing inequality in the developing world, thus reducing Western security costs. Above all, the investment returns could help chip away at the current pension deficit.
Creating change requires incentives and deterrents. Long-term investors in EMs recognise that the relative shortage of shareholder activism allows many issuers to maintain weaker capital discipline and thus pay softer service to investors.
In our view, EMs could go much further on governance reform, but they will not achieve this alone. The pension fund industry needs to do more to address current shortfalls; encouraging shareholder activism may present a way forward. The benefits would be clear: a more prosperous stable emerging world would export fewer problems, while mature market pension funds would participate in a general increase in prosperity while meeting their return objectives.
PIONEER INVESTMENTS DISCLAIMER
Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of December 2016. The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investment product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies.
This is a sponsored article from Pioneer Investments.