Exposure to the emerging markets story, but with a twist

Certainly the term has rarely been associated to emerging markets assets. However, within our investment portfolio we see no argument not to favour greater tactical exposure to emerging market bonds in order to help support dynamic asset allocation strategies during risk-off periods.

The fund’s current allocation to emerging market bonds is around 40% and in recent weeks we have tilted the portfolio towards more defensive markets such as Malaysia and Indonesia.

We have also established a long position in the Chinese Renminbi, a currency we expect to appreciate against western currencies. Within the market context, the portfolio allocation has proved to be fairly defensive so far.

There is a caveat to this, as we should also point out that the most recent market sell-off has hit all emerging markets.

Credit spreads have generally widened and currency markets have generally started to sell-off too as a consequence of investors deserting all risk assets and retreating to the US dollar.

For example, in July and August emerging market debt showed resilience, with emerging market bonds up around 0.85% in US dollar terms, while emerging equity markets sold off by around 10.7%.

In September, emerging market equities have largely outperformed their bond equivalents and this changing investment dynamic reinforces our argument that bolting bond and equity allocation together is not sufficiently robust to give investors risk-controlled exposure to emerging markets.

While past performance is not a guide to future performance, we hold the view that asset returns in emerging economies will continue to outperform returns in the developed world over the medium and long-term.

In our view, emerging markets have been shown to deliver strong returns, underpinned by a favourable demographic profile, local currency appreciation, high productivity and growing domestic demand.

Recent noise emanating from the developed regions in the main hasn’t changed this belief.