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 requirements 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 crises; today, they account for more than 60% of global GDP.
It is estimated by PWC that by 2050, the GDP of the seven leading EM countries will be more than double that of the current G7.
Factors driving EM 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.
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, EM 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.
