New emerging markets math: debt versus equities

As advisors work to diversify client portfolios, they typically devote a certain percentage to emerging markets securities. Depending on their clients’ needs and their own specialties, some wealth managers are less attuned than others to the percentage devoted to emerging market equities versus emerging market debt. But after a spectacular 20-year run, advisors will need to pay more attention, say two top fund managers at Fidelity Investments.
The outlook for yield on emerging markets debt, as well as the slow or slowing pace of global economic growth, are not especially bearish, but more of an indicator that emerging markets equities may be a wiser asset allocation.
Brian Drainville, an institutional portfolio manager at Fidelity, said at the recent Investment Management Consultants Association conference in Seattle that, just “like in developed markets, a debt-equity mix in emerging markets can offer diversification benefits.” As sovereign creditworthiness improves, he added, “The factors that drive debt and equity change.” At the end of 2003, the investment grade portion of emerging market securities was less than 35%. By the end of 2012, it stood at about 65%, according to JPMorgan research.
An emerging markets strategy is an essential part of a client’s portfolio, he said, because “emerging markets cover about 80% of the globe, whether you talk about geographically or from a population perspective -- and are moving up on a contribution to GDP basis, as well.” In a recent report by Drainville and Fidelity mutual fund manager John Carlson, they estimated that countries in emerging markets represent more than 40% of global GDP.
They added: “Due to the decline in yields, it is important going forward for investors to recalibrate their expectations for emerging markets debt. No longer characterized solely as a high-risk/high-reward category, emerging markets debt has broadened into a more diversified asset class, and we believe these diversification qualities will be among the primary drivers of its future returns.”
As for emerging markets equities, Carlson told wealth managers at IMCA: “Looking forward, my bold prediction is it’s going to be better than most people think now. The problem is if you get in early, then you think, well, I’ve ridden it long enough, it’s time to get off. And if you missed it, you keep thinking you missed it” and remain on the sidelines.”
Carlson, who Morningstar named as its 2011 Fixed-Income Manager of the Year, said he expects long-developing trends to propel emerging markets in the years to come. “In Asia, where you had an export model for at least 30 years, that’s changing – there’s going to be a bigger focus on domestic consumption and that’s already taking place. You see it in China, you’re seeing more regional trade [within countries],” he added.