What role could Emerging Markets play in my investment strategy?This is a common question asked by pension scheme investors, and following a summer of bad news in relation to a number of specific Emerging Market countries, it has never been more relevant.

In this short note we walk you through the key issues that have affected Emerging Markets of late and share our ideas around the role that Emerging Markets can play in a pension scheme’s portfolio.

What defines an Emerging Market? Index providers use different metrics to classify countries. Broadly speaking Emerging Markets can be summed up as being countries that have a notable global economic presence and economic output, whilst having sufficiently liquid, transparent, accessible and sophisticated markets to meet the requirements of the Emerging Market classification, but insufficient to be classified as Developed Markets.

Countries that don’t meet the Emerging Market criteria will often fall in the Frontier classification. The nature of the criteria and classification means that some countries sit near the threshold between Emerging and Frontier. For example Argentina, historically in the MSCI Frontier Market, will transition into the MSCI Emerging Market index in June 2019, whilst FTSE Russell will continue to include the country in their Frontier index. Saudi Arabia is due to become an Emerging Market country for both MSCI and FTSE Russell in 2019, despite not currently featuring in either Frontier Market index. The recent troubles in relation to Saudi Arabia are not reported to have any impact on this plan. But, it is not inevitable that countries will naturally progress from Frontier through to Emerging Markets, and ultimately Developed Markets. Some countries suffer from substantial issues such as political regimes or geographical and environmental issues that are likely to constrain their development for the foreseeable future.

In brief- Emerging Markets have

experienced a rocky ride in recent months

- But both Emerging Market equity and debt can play an important role in a diversified portfolio where the allocations are carefully managed

Next steps- There are a variety

of ways to access Emerging Market equity and debt investments to reduce risk and enhance return without excessive governance

xpsgroup.com

Investment briefingNovember 2018

Simeon WillisChief Investment Officer

The strongest case for investing in Emerging Markets is the strategic case, rather than the tactical one

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Recent headwindsWhilst being a hugely diverse collection of economies, there are several notable factors that are common to many. These have been prominent in recent months:

International trade: In general Emerging Markets are exporters meaning they are vulnerable to protectionist policies. Any tariffs, sanctions or trade frictions can significantly hamper their output.

Recent events: US trade tariffs: The trade tariffs being rolled out by the US government have affected many countries, whilst China has been in the news with 10% tariffs on $200bn of exports rising to 25% in the absence of further deals, Turkey and South Africa amongst others have been affected with tariffs, for instance, on steel exports.

Currency risk: Emerging Markets usually have currencies that are more volatile than Developed Market currencies and typically are very expensive to hedge for an international investor. A way round this has been for Emerging Market borrowers (both governments and corporates) to issue debt in ‘hard currency’ – e.g. issuing in US Dollars. Whilst local currency depreciation need not affect hard currency investors directly, indirectly Emerging Market countries will struggle to pay back their debt where their local currency significantly depreciates, increasing likelihood of default – which prompts falls in asset values.

In addition to this, contracts between companies are often agreed in dollars, meaning that changes in exchange rates can have a substantial impact on corporate operational costs, placing inflationary pressure in the event of currency depreciation.

Recent events: Rising US interest rates: The US is part way through a program of raising interest rates, known as ‘monetary tightening’. It is trying to keep the economy on path and avoid excessive inflation (following years of printing money following the global financial crisis) whilst not raising rates too quickly, suppressing economic growth. This challenges Emerging Market currencies as higher interest rates will typically attract investors to invest in dollars, strengthening the dollar versus other currencies. This leads to Emerging Market currencies depreciating, and with that greater pressure on corporate profitability, and ability to repay debt. The Emerging Market governments can respond by increasing their interest rates, but this can suppress their economy. Some Emerging Market countries have only just emerged from recession and high interest rates can hamper progress (e.g. Argentina).

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Emerging Markets according to MSCI classification

Americas Europe, Middle East & Africa Asia

BrazilChileColombiaMexicoPeru

Czech RepublicEgyptGreeceHungaryPolandQatarRussiaSouth AfricaTurkeyUAE

ChinaIndiaIndonesiaSouth KoreaMalaysiaPakistanPhilippinesTaiwanThailand

Source: MSCI

Emerging Markets according to FTSE Russell classification

Advanced Emerging Secondary Emerging

BrazilCzech RepublicGreeceHungaryMalaysiaMexicoSouth AfricaTaiwanThailandTurkey

ChileChinaColombiaEgyptIndiaIndonesiaKuwaitPakistanPeruPhilippines

QatarRussiaUAE

Source: FTSE Russell

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“ What is the Emerging Market currency risk premium all about?Within Developed Markets, currency risk in the main is considered an unrewarded risk. Hedging markets are well established and the cost of hedging is defined by the difference in the ‘risk free’ interest rate of the two countries in question. With high credit quality governments such as UK or US, risk free does tend to mean very low risk, but within the Emerging Markets the concept of a ‘risk free’ interest rate is somewhat loose. This means that in general you expect to earn a risk premium simply by holding a currency and investing to earn the local government interest rate. This can be thought of as a currency risk premium.

But you cannot earn a currency risk premium if you hedge the currency risk. Often a large part of investing in a local currency Emerging Market equity or bond is the currency risk premium. But it can sometimes be costly, as we saw this summer with the depreciation of currencies across a number of prominent Emerging Market currencies including the Turkish Lira, South African Rand and Argentine Peso.

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So is it all bad news?It is not all bad news for Emerging Markets. Firstly the ebbs and flows of Donald Trump’s negotiation style means that the outcome of the current international trade talks have potential to be much better than feared. For instance Mexico started the year concerned about its trade with the US but the latest developments with the NAFTA deal between US, Canada and Mexico look promising.

Also, despite the falling growth rate of many countries, this is often from a higher base level of growth than many Developed Markets and there are structural reasons why Emerging Markets could plausibly continue to grow more quickly than Developed Market economies. These include rising literacy and skills, and improving infrastructure. However, it is also important to acknowledge that economic growth does not necessarily correlate to investor returns. So a falling growth rate may not be bad for investor returns. There are many possible reasons for this, but one example is that in any growing economy there is a sharing of wealth generation between capital and labour, i.e. the balance between investors earning higher returns and/or the population benefitting from higher wages. This balance shifts considerably through time. Add to this that future growth expectations are already priced in, meaning that the relationship between growth and market returns is loose at best.

The strongest case for investing in Emerging Markets (as with many asset classes for a long term investor) is the strategic case, rather than the tactical one. Emerging Markets offer scope to diversify risk across more underlying entities (e.g. companies) and thereby improve the overall portfolio.

What are the opportunities?Emerging Market equityEmerging Market equity has featured in UK pension scheme investments for many years. We would continue to support clients making an allocation to Emerging Markets as part of their overall global equity allocation, and would avoid currency hedging given that the reduction in risk is not significant enough to justify the cost of currency hedging. A prominent component of the expected return comes from the currency risk premium, which is forgone

when hedged to sterling. Currency hedging would also be complex to administer given the number of markets involved and it is not readily offered in the UK market.

There are a range of global all-world equity and Emerging Market specific funds that can provide cost effective access to Emerging Markets in a low governance approach. Similarly, Diversified Growth Funds can provide exposure where the fund manager is deciding on an appropriate level of exposure in the prevailing market environment.

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2013 2014 2015 2016 2017 2018EM Equity (£) EM Equity (Local)

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2013 2014 2015 2016 2017 2018EM Sovereign (Hard) EM Corporate (Hard) EM Sovereign (Local)

Notes: The JP Morgan EMBI Global Diversified Index has been used to represent EM Sovereign (Hard), the JP Morgan CEMBI Diversified Index has been used to represent EM Corporate (Hard), the JP Morgan GBI-EM Composite has been used to represent EM Sovereign (Local)

Notes: The FTSE Emerging Index has been used to represent Emerging Market equity

Emerging Market equity performance Emerging Market debt performance

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Please note the information and opinions expressed herein do not take into account the circumstances of individual pension funds and accordingly may not be representative of the circumstances affecting your fund. This note, and the work undertaken to produce it, is compliant with TAS 100, set by the Financial Reporting Council. No other TASs apply. The note has been written on the basis that decisions will not be based on its contents. Appropriate advice should be obtained before any decisions are made. The information expressed is provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This document may also include our views and expectations, which cannot be taken as fact. The value of investments and the income from them can go down as well as up as a result of market and currency fluctuations and investors may not get back the amount invested. Past performance is not necessarily a guide to future returns. The views set out in this document are intentionally broad market views and are not intended to constitute investment advice as they do not take into account any client’s particular circumstances.

Please note that all material produced by XPS Investments is directed at, and intended solely for the consideration of, professional clients within the meaning of the Financial Services and Markets Act 2000 (FSMA). Retail or other clients must not place any reliance upon the contents. This document should not be distributed to any third parties and is not intended to, and must not, be relied upon by them. Unauthorised copying of this document is prohibited.

This document should not be distributed to any third parties and is not intended to, and must not be, relied upon by them. Unauthorised copying of this document is prohibited.

© XPS Investment 2018. XPS Investment is the trading name of Xafinity Consulting Ltd and Punter Southall Investment Consulting Ltd. Registration: Xafinity Consulting Ltd, Registered No. 2459442. Registered office: Phoenix House, 1 Station Hill, Reading RG1 1NB. Punter Southall Investment Consulting Ltd Registered No. 6242672. Registered office: 11 Strand, London WC2N 5HR. Both companies registered in England and Wales. Punter Southall Investment Consulting Ltd (FCA Register number 528774) and Xafinity Consulting Ltd (FCA Register number 194270) are both authorised and regulated by the Financial Conduct Authority (FCA) for investment business.

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Emerging Market debtWe believe there is an important role for Emerging Market debt to feature as a diversifier within a UK pension scheme’s credit portfolio. The key issue is avoiding introducing excessive risks in the process, namely currency risk and regional interest rate exposure.

There are two main types of debt issuers: government and corporate. They can issue two broad types of debt: local currency and external ‘hard currency’. Around 90% of debt is issued in local currency, but for reasons we’ll explain, hard currency is a more popular choice for international investors.

Hard currency corporate and government debtContrary to common perception, hard currency Emerging Market debt is often no more risky than Developed Market credit investments of comparable quality. The US dollar currency risk can be hedged straight-forwardly allowing the investor to access a diverse pool of investments that complements a Developed Market credit portfolio.

That said, there is an issue that rising dollar interest rates like we are seeing currently, can place the country under greater pressure. Rising rates can increase the cost of debt interest payments, which is an issue particularly when it comes to issuing new debt.

Hard currency corporate and government debt can feature as a meaningful allocation within a global low risk credit portfolio, bringing benefits of additional diversification and reducing risk, and modestly enhancing return.

Local currency corporate and government debtLocal currency debt investments introduce a near obligation to run the currency risk, as Emerging Market currencies are typically very expensive to hedge. As such the role that the bond can play within a portfolio needs to be carefully assessed against the additional risk.

Even with a strong underlying issuer such as a government, the currency risk has scope to vastly overshadow the return of a bond investment.

This means that the role for local currency Emerging Market debt is very limited within low risk credit portfolios, but can feature in medium risk portfolios albeit to a relatively small degree and on a selective basis.

There are a number of good quality multi sector credit funds of differing risk/return targets that feature Emerging Market debt, managed appropriately by a competent investment manager, as part of a diversified credit strategy with low trustee governance requirements.

For further information

t 020 3327 5000

e simeon.willis@ xpsgroup.com

@xpsgroup.com

company/ xpsgroup

If you wish to discuss this further please contact Simeon Willis or your regular XPS contact.

Rising US rates can increase the cost of hard currency debt interest payments, which is an issue particularly when it comes to issuing new debt.