While emerging markets have been underperforming their developed counterparts over the past decade, this may be about to change.

“Basically, everything went wrong in emerging markets in the last 10 years,” said Laurence Bensafi, deputy head of emerging markets equity at RBC Global Asset Management Inc., in a webinar hosted by the Association of Canadian Pension Management on Thursday.

Two decades ago, this wouldn’t have mattered to Canadian pension plans since they had little to no exposure to emerging markets, she noted. And while allocations to these markets have been rising, some pension plans may be on the cusp of adding more.

Read: Which emerging markets should institutional investors be considering?

Indeed, Bensafi cited research that found public emerging market equities were among the hottest assets that pension plans are looking to add, along with alternatives, such as infrastructure and real estate. “We would say plans are underweight where they might want to be.”

For pension plans to understand the opportunity here, they should analyze why emerging markets have under-performed in recent years, she said. China’s slowdown in growth played a major role in pulling down the category overall. Further, the trade war between the U.S. and China, as well as other trade skirmishes, have dampened sentiment considerably. And it has meant less liquidity in China and the U.S. markets, causing knock-on effects globally.

Bensafi also noted that two major players, Brazil and Russia, entered deep recessions during the past decade. Meanwhile, Europe and the U.S. recovered much more quickly than anticipated from the global financial crisis, making their market performance appear far better by comparison. “It’s not surprising investors in that kind of environment have preferred U.S. equities,” she said.

Read: What Argentina’s historic market crash means for institutional investors

Emerging markets’ differential to their developed counterparts is another reason for the recent slowdown in allocations to the asset class, said Bensafi. She noted markets are expecting that differential to widen in 2020, which could be a major trigger for emerging market allocation.

“One thing that has changed and been quite dramatic over the past few months has been the change in expectation of monetary policy.”

The difference in tone away from interest rate increases towards cuts is a massive reversal, she said. It could mean a weaker U.S. dollar, which would be a boon to emerging currencies. However, it all depends on how cautious the banks want to be with key bond yield curves at the point of inversion. Whether the cuts remain precautionary or become recessionary, time will tell. But, at the moment, the fact that central banks are taking an active role is a good sign for both emerging and developed markets, said Bensafi.

She also stressed that institutional investors shouldn’t be blinded by short-term events. “We are cautiously optimistic and, for us, the most important message is that EM is an asset class where we want to be invested in the long term.”

Read: Are investor portfolios structured to withstand a market correction?

Certain markets are especially exciting today, she noted. In assessing China’s capacity for further growth, for example, she pointed to the amount of activity going on in the country’s technology sector. One factor of the U.S./China trade disputes is that China traditionally gets most of its higher tech components from abroad, such as semiconductors, and will need to begin looking elsewhere or boost its internal capabilities.

A significant amount of China’s gross domestic product is also related to research and development, said Bensafi, noting the country is on a tear of patenting innovations. “These numbers are going through the roof. They’ve been spending a lot of money to catch up.” 

Some may point to China’s significant debt levels as cause for concern, but she noted most of the debt is held by the country’s non-financial corporates, rather than the government or consumers. The government is tightening restrictions on borrowing by these corporates, meaning that while growth may slow, the growth itself will be of better quality.

Read: Are tensions between China and the U.S at trade war level yet?

Meanwhile, Brazil may on the cusp of much-needed improvements, said Bensafi, noting there’s a lot of room for growth because the country is basically bankrupt as it stands today. Also, Brazil doesn’t have a huge amount of foreign investments.

“Brazil is one of the worst when it comes to tariffs, one of the most closed-off economies in the world,” she said. The country’s companies aren’t especially competitive on a global scale, she added, noting since the economy is so closed-off, they have no reason to rival their global peers.

It needs major economic reforms in order to turn it around. Its relatively new president Jair Bolsonaro’s policies could give it the boost it needs, said Bensafi, but it’s a matter of whether he can actually achieve them. “It’s not going to be a straight line. It’s going to be volatile.”

Read: Geopolitical tensions high on investors’ list when examining emerging markets

India is another favourite, she added. “It’s a country that is much behind the other countries where we invest. India is like where China was 20 years ago. There’s a lot of potential for growth.”

Indeed, among other emerging markets, India’s expected growth of eight per cent for the coming year is remarkably high, said Bensafi, noting the current mild selloff in its markets could represent a buying opportunity, but it also serves to highlight just how difficult timing these markets can be.

“Traditionally, it’s one of the most expensive countries in emerging markets.”

Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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