Getting ahead of the emerging markets curve

Emerging market (EM) equities are seeing strong inflows as investors respond to developing global trends and rotate capital into the space

Getting ahead of the emerging markets curve

Emerging market (EM) equities are seeing strong inflows as investors respond to developing global trends and rotate capital into the space. We expect this dynamic to continue, which would create an attractive opportunity to get ahead of these flows and to benefit from the strong relative performance we anticipate.

So, why is the smart money piling into emerging markets?

We believe it is principally due to the following trends:

1. Expected consequences of the current monetary and fiscal policy environment

2. Emerging Asia’s relative economic outperformance during the pandemic

3. Long-term diversification benefits

For investors looking to capture this opportunity, we believe Purpose Emerging Markets Dividend Fund (REM) provides a unique and superior approach.

1. The current policy environment

Although quantitative easing has become a common policy tool since the 2008 global financial crisis, the magnitude and scale of security purchases by the Federal Reserve and other global central banks became extraordinary in 2020. More recently, the Fed’s language has shifted to embrace the concept of inflation averaging, which allows for CPI growth to temporarily exceed the targeted 2% rate to offset an episode of slower inflation or deflation.

This represents a material change to the decades-old monetary policy focus on inflation targeting. It is now clear that central banks, led by the US Federal Reserve, are prepared to maintain loose policy for longer, letting inflation run “hot” should we see moderate, sustained upward pressure on prices.

The fiscal policy picture has also become materially bullish in the wake of the Democrat’s surprise wins in the Georgia run-off elections. This outcome has handed the party control of the Senate in addition to House of Representatives and the White House. Massive new stimulus along with the additional borrowing necessary to fund it is now all but guaranteed.

While these developments are tailwinds for economic growth, they also drive an expectation for US dollar weakness. EM equities have historically benefited from downward pressure on the US dollar and have been quietly picking up steam more recently.

Looking at the historical relationship between EM equities and the US dollar, apart from the period around the Brexit vote in mid-2016, the dollar demonstrates meaningfully negative correlation to movements in the emerging market index over time. With the expectation for a softer US dollar, investors should be seeking broader international exposure. EM equities are a noted historical beneficiary of this dynamic.

Emerging market versus USD relative strength
Source: Bloomberg API, December 31, 2020.

2. Superior COVID management

Although COVID-19 may have originated in Asia, countries in the region have done a better job containing the virus and its economic impact. The following table illustrates the pandemic’s impact on 2020 GDP growth and forecasts for 2021. EM countries, particularly in Asia, sustained positive growth through last year and are poised to expand the most in 2021.

COVID GDP impact and recovery chart by Country
Source: Bloomberg API, December 31, 2020.

Indeed, China was the first among major economies to regain its prior peak in economic activity. This is a striking contrast, particularly in consideration of the disconnect in price-to-earnings multiples, which show EM equities remain quite cheaply priced, particularly in China.

3. Diversification

Emerging markets have long provided Canadian investors with diversification benefits. Although the asset class itself can be volatile, the movements tend to differ in timing relative to developed markets. This minimizes the impact of volatility at the portfolio level while being additive to expected return. This is due in part to the different composition of these economies versus their counterparts in developed markets.

For example, while the Canadian economy is concentrated in pro-cyclical sectors such as financials, energy and real estate, EM economies tend to tilt toward the manufacturing and materials sectors. An allocation to EM enables superior portfolio diversification, both geographically and from a sector perspective.

The following chart illustrates changing leadership over time among a collection of international equity benchmarks, and why it pays to incorporate broad global exposure in a well-diversified portfolio.

Global equity market leaders
Source: Bloomberg API, December 31, 2020.

The more thoughtful way to invest in EM

Purpose Emerging Markets Dividend Fund (REM) provides a unique solution for investors that emphasizes yield-generation through dividends and options premiums while providing a broader exposure to traditional dividend stocks and index-leading growth equities.

With the global surge of the information technology sector and long-term secular trends that point to ongoing strength, running a traditional dividend strategy that will inherently exclude most growth companies may not satisfy investors’ needs universally. REM is designed to deliver the best of both worlds.

We designed the Fund with a quantitative dividend strategy at its core (70-80% of NAV), combining it with a cash-covered put-selling strategy (20-30% of NAV) to build a more diversified portfolio. For example, one of the primary use cases of selling puts is to establish positions in leading index constituents that are non-dividend paying (think Alibaba or Tencent), while generating a premium from the exposure. This provides the Fund with exposure to these transformative companies while enhancing yield generation relative to a conventional dividend approach.

There are many dividend funds in the market with mandate flexibility to invest in these kinds of companies, but the key is that REM does so while staying true to its core objective of generating an attractive yield.

The strategy has historically and is expected to continue to provide:

  • Capital appreciation with lower volatility than a broad EM index
  • High yield generation versus both broad index and dividend fund competitors
  • Superior performance relative to competitor dividend funds in an environment where technology and growth stocks continue to lead

This has been borne out by the Fund’s performance since we changed the manager and strategy in July 2019. We believe it delivers a happy medium between a straight EM dividend mandate and a more volatile index exposure.

REM performance chart
Source: Bloomberg API, December 31, 2020.

— Graeme Cooper is Vice President of Product at Purpose Investments


All data sourced to Bloomberg unless otherwise noted.

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