Executive Summary

This paper highlights five reasons why Emerging Markets (EM) in aggregate are more resilient today than in prior periods. A “healthier” index composition in addition to four other reasons support our analysis that EM drawdowns will be significantly more muted than previous peak- to-trough drawdowns. The 30% rebound that the asset class has experienced since its trough in late March is in line with our thesis of a more robust index. In GMO’s recent Quarterly Letter, Ben Inker, Head of our Asset Allocation team, made the case for emerging stocks given their lower relative valuations.

We acknowledge the heterogeneity of the asset class but take comfort in China at 40% of the MSCI EM Index being resilient, with better growth prospects and plenty of residual dry powder. Not only has the weight of cyclical sectors like Energy and Materials shrunk (from 30% to 12%), there has also been a significant improvement in their balance sheets. Some domestic consumer-driven and growing sectors such as Information Technology and Internet/Media names are now nearly one-third of the index. In our April 2020 paper, “Covid-19: Risk and Resilience in Emerging Markets,” we provided a framework to assess the most vulnerable EM nations and those best placed to emerge less scathed than others from the pandemic. We identified only 9% of emerging countries as high risk vs. 66% as safe countries.

However, the EM asset class is innately characterized by risk – this paper discusses five such risks and cautions of other uncertainties that can morph into risk. While some traditional risks have abated, we discuss tensions from a renewed U.S.-China trade war, domestic power struggles in some of the larger EM countries like Brazil and India, constraints on the coffers of EM governments, and both currency and concentration risk. As we construct our EM portfolios today, we strive to take advantage of the lower volatility of the asset class while maintaining a defensive stance to mitigate the heightened risks in today’s environment. Net/net, however, we believe many of the EM-specific risks are navigable.