Emerging Markets Outlook

Political Risk and the "Emerging Markets Now" Paradigm

• Political risk is no longer exclusive to emerging markets (EM); it has become a universal factor affecting global investment decisions.
• Formerly distinct EM characteristics—including legal opacity, nepotism, and arbitrary law application—are increasingly prevalent in developed markets like the U.S., where political figures can now move global markets via social media.
• Investors are advised to adopt a "political economy" mindset, acknowledging that qualitative political inputs are often determinative of financial outcomes.
• The traditional distinction between developed and emerging markets has blurred, with the consensus that "we are all emerging markets now."

Market Evolution and Structural Shifts (Past 10–20 Years)

• Diversification & Instruments: Post-2008 financial crisis, the development of ETFs and new investment instruments enabled instant liquidity access to EM and frontier markets, which were previously considered too risky.
• Credit Quality Improvements: The JP Morgan EM Bond Index transformed from ~10% investment grade in the 1990s to over 50% today.
• Geographic Expansion: The EM bond universe expanded from 38 countries in 2008 to 67 countries currently.
• Valuation Gap: EM assets currently trade at roughly half the valuations of the U.S. and Japan, though Europe lags behind this metric.
• Growth Divergence: EM growth relative to developed markets is widening, creating a strong pull factor for foreign direct investment (FDI) and equities.
• Sovereign Debt Composition: Approximately 75% of sovereign debt is now denominated in local currency (up from nearly 100% hard currency in 1998-99), reducing balance sheet vulnerability to currency devaluation.
• Corporate Debt: Corporate debt remains disproportionately dollar-based, as domestic investors in EM are primarily "rates buyers" rather than credit buyers, leaving a gap in local currency corporate bond markets.

Macro Outlook and Investment Themes

• Cycle Positioning: EMs are currently viewed as being in the "early to early-mid cycle," contrasting with the "late cycle" U.S. economy, making them less vulnerable to capital withdrawal than in 2013.
• Inflation & Rates: Inflation remains low due to negative output gaps in many economies, while real rates are high.
• Demographics & Consumption: China and India now account for a GDP share 10% higher than the U.S. (in PPP terms); EMs are shifting from cyclicality (materials/energy) to consumption-oriented models.
• Sector Composition: MSCI China offshore listings are 40% technology/domestic, compared to 25% in the U.S. and 11% in Europe.
• Domestic Capital Flows: EM pension funds typically allocate only 10% to equities (vs. 60% in US models), leaving massive potential for institutionalized domestic savings to enter capital markets.
• Currency Trends: A longer-term dollar weakening cycle is anticipated, punctuated by countertrends of 5-7%; currency volatility may become a primary driver for equity and local currency bond returns.

Investment Methodologies and Strategies

• Fixed Income Approach:
  • Focus on "top-down" identification of political and economic turning points rather than static credit analysis.
  • Sovereign research teams target countries undergoing significant structural or policy changes to capture value ahead of the market.
  • Local currency bond returns are attractive but carry high risk in countries with weak institutional frameworks (e.g., Turkey), while USD-denominated bonds historically yield ~300 basis points over developed markets.
• Equity & Activism (Cardica Management):
  • 85% of EM listed companies are controlled by families, founders, or the state; activism must be constructive rather than confrontational.
  • Successful interventions focus on "low-hanging fruit": improving English disclosure, removing non-core businesses, establishing succession plans, and enhancing analyst coverage.
  • Case Study: A Peruvian company doubled in value in 18 months after activists secured English reporting, segment reporting, and a clear succession plan.
  • Case Study: An attempt to convert a Brazilian offshore listing to an onshore listing failed due to the controlling shareholder's resistance, highlighting limits of influence in entrenched environments.
• Operational Perspective:
  • Corporate operators view EMs as resilient; essential sectors (e.g., food) grow regardless of political instability.
  • Unpredictability and political volatility are currently perceived as higher in Western economies than in many EMs.
  • A "risk-reward mismatch" exists where distant, passive fund managers overestimate risk due to comfort zone biases, missing opportunities in emerging markets.

Regional Focus: Mexico and Trade

• Electoral Context: A ~90% probability exists for Andres Manuel Lopez Obrador to win the Mexican election, though institutional reforms (requiring supermajorities) have strengthened the framework.
• Trade Agreements: Mexico is advancing multiple trade deals, including the updated NAFTA (USMCA), agreements with Europe, and the CPTPP.
• Supply Chain Resilience: Despite tariff threats, foreign direct investment (FDI) in Mexico is robust, particularly in automotive, aeronautical, and electric manufacturing.
• CPTPP Impact: The agreement has redirected automotive and textile supply chains (e.g., from Australia/Vietnam) to Mexico, boosting raw material imports and manufacturing depth.
• Currency Risk: The Mexican peso has been a top performer; however, the administration's rhetoric on trade imbalances creates volatility that can impact export competitiveness.

ESG and Governance

• Social & Environmental Enforcement: In EMs, investors often must enforce local safety, labor, and environmental laws internally due to weak regulatory oversight.
• Governance as Value Driver: Improving governance yields the highest re-rating potential, specifically through:
  • Capital Allocation: Reducing excess cash on balance sheets to increase Return on Equity (e.g., shifting from 35% to 55% ROE).
  • Internal Controls: Implementing robust KPIs and measurement systems to enable growth.
• Greenwashing Warning: Past instances show companies re-rating purely on the use of "corporate governance" terminology without substantive operational changes (e.g., Russian companies in 1999).

Forward-Looking Statements and Asset Class Outlook

• Yield Environment: EM fixed income offers relative value with yields in the 6%–6.5% range, contrasting with <2% yields in 45% of the global opportunity set.
• Local Currency Bonds: The "risk-free asset" is currently non-existent; the concept of a risk-free asset in EM is a multi-year transition dependent on the evolution of the U.S. Treasury market's own risk profile.
• China's Influence: China is aggressively expanding influence via the Belt and Road Initiative, offering low-cost debt and strategic partnerships that bypass traditional corporate considerations in South Asia, Africa, and Central Asia.
• Fintech & Blended Finance: Project financing is evolving toward blended models (traditional bank + funds + fintech) to mitigate risk and accelerate execution.
• Market Outlook: The EM cycle is expected to run for another 9–10 years; investors must exit comfort zones to capture returns in "unexplored" markets with first-mover advantages.
• Risk Warning: While sovereign risk is mitigated, corporate leverage remains a concern, particularly in China, though policy focus on deleveraging is increasing.