The Evolving Landscape of Emerging Markets: From a Golden Age to a Multipolar Future | AlphaWeek

Emerging markets are inevitable.

Together, these economies account for more than 80% of the world’s population and 43% of global GDP; over the past ten years they have been responsible for about two-thirds of international economic growth. Meanwhile, public capital markets in these economies have grown to over $50 trillion, compared to about $185 trillion in developed markets.

But while the established opportunities are huge, the total AUM of hedge funds focused on emerging markets has shrunk to just $250 billion. $250 billion – according to Hedge Fund Research – chasing the opportunity set in a $50 trillion market. The extent of this mismatch creates continued opportunities for sophisticated hedge funds operating in the EM space.

In our view, the EM investment opportunity has transformed from long-biased, value-driven portfolios to a nuanced and agile proposition that follows positive and negative trends, market-neutral carry opportunities and displaced value . To understand why opportunities have shifted so markedly, it is important to understand the profound change in emerging markets over the past few decades.

The Golden Age of Emerging Markets

The fall of the Berlin Wall in 1989 marked a turning point for the developing world. In its wake, a remarkable confluence of positive economic, political and trade factors brought about a remarkable period for emerging market countries and assets – a time of unprecedented growth and transformation. This era, which lasted until approximately 2015, saw emerging economies grow as major players on the global stage and emerging market assets enjoy multi-year runs.

In economic terms, the jump was driven by a combination of more workers and significantly improved productivity, which combined significantly to accelerate EM growth rates.

At the heart of this golden age lay a powerful “demographic dividend”. Between 1989 and 2015, the working-age population of the developing world grew from 2.4 billion to 4.0 billion. This dramatic growth across emerging giants such as China, India and Latin America provided a large labor pool, also fueling domestic consumption as these young workers entered their prime earning years.

Complementing the demographic advantage was a global productivity boom. Developing economies quickly adopted best practices and technology from developed countries: Eastern European countries joined the EU and embraced efficient production processes; China, South Korea and Taiwan became the factory floor of the world; and India became its outsourcing hub. This technology transfer, alongside domestic innovation and the movement of workers from rural agriculture to urban manufacturing and services, saw emerging markets rapidly shrink the productivity gap with the West. EM productivity grew by over 6% annually 1989-2015 on the fast track of China, India and Central and Eastern Europe, over 4 times the rate of the West.

Beyond extremely positive internal factors, a supportive external environment further fueled this growth. The new unparalleled dominance of an optimistic, liberal, capitalist Washington consensus that emphasized free markets and globalization fostered an environment conducive to investment, trade, and international capital flows. EM was the main beneficiary of this environment, as a move to reduce trade barriers led to a transfer of IP and the integration of developing economies into global supply chains; while low interest rates in developed markets spurred much-needed capital flows to finance economic transformation.

The fall of the Berlin Wall played a key role in ensuring that the global geopolitical backdrop was as positive as the macroeconomic backdrop. The “peace dividend” following the breakup of the Soviet Union brought a period of relative stability, allowing emerging markets to focus on domestic development without the burden of Cold War anxieties. The US, acting as the global “North Star”, provided a sense of direction and security, encouraging reforms and promoting good governance practices. This fostered an environment where investors perceived lower risks, leading to lower risk premiums and increased capital flows to emerging markets.

The results were profound. According to IMF figures, EM recorded annual GDP growth of 7-8% during this period – compared to 2-3% in the developed world. 1.3 billion people were dispossessed, the greatest social improvement in human history, while over a billion joined the global middle class. This paradigm shift fundamentally reshaped the global economic and political landscape.

The consequences for asset markets were also dramatic. For years, EM markets consistently outperformed their DM equivalents – and a generation of emerging market managers learned to structure their investment processes around a long bias and a value anchor.

Complexity, distribution and opportunity in a multipolar world

The past ten years have seen a significant change in the economic and political landscape of emerging markets compared to the golden age. The general positivity of the post-Cold War era has been replaced by sheer complexity, dispersion, and divergence. Not only are there many more EM countries with liquid tradable asset markets than twenty years ago, but now some of these countries have strong economic fundamentals and some weak; some are pursuing positive macroeconomic and political reforms – and some are not. With less uniformity, EM countries now have extremely important political and economic cycles that are much less correlated with the rest of the world.

This can be clearly seen in the growth figures. Overall, EM growth has slowed from 7-8% to 4-5%, something of a reversion to the mean after the extraordinary golden age years, but many countries continue to post stellar numbers. Consider India, whose 8.2% growth last year accounted for just 16% of global GDP growth.

India’s young workforce continues to grow, supporting this growth, with dependency ratios set to peak only in 2040. The same or more can be said for other parts of Southeast Asia, the Middle East and Africa Sub-Saharan, but China’s working age population reached a sharp peak in 2014, while in Latin America it is growing gently this decade. Further highlighting the complexity, some countries have been very effective in harnessing these young workers to boost productivity; in others, the lack of jobs for a new generation of young people will endanger social stability.

Even internationally, the background is now much more complex under the hood. Perhaps the essential political text to capture the geopolitical zeitgeist of the Golden Age was Francis Fukuyama’s The End of History—the idea that liberal, capitalist democracy had defeated all other political ideals; in contrast, we believe that the current era is best characterized by Samuel Huntington’s Clash of Civilizations, originally written as a response to Fukuyama. The US – and the system it represents – is no longer the undisputed global hegemon: countries now have a variety of governance models to choose from. The success of China’s state-led development model offers an alternative path, emphasizing government investment in strategic sectors, industrial policy, and infrastructure development, while de-emphasizing democracy, liberalism, and governance reforms. The Gulf and even Russia offer alternative choices: the former combining most of China’s economic and governance models with a geopolitical willingness to find accommodation with the West, with the latter focused on kleptocratic state capture and antagonism to the US .

International geopolitics has undoubtedly become a driver of the global economy and asset markets. This is especially true for low-income countries in a world where private financing is increasingly limited. In the wake of the global financial crisis, the stock of private capital available to emerging markets has been radically reduced by higher capital ratio requirements, smaller bank balance sheets and a move towards exchange-based execution. Before Covid, this change was somewhat masked by the effects of low rates and QE, but not anymore. These developments place an increased emphasis on bilateral and multilateral financing, where we increasingly see countries’ geopolitical reach and geopolitical importance overpowering economic fundamentals to dictate access to financing. Countries that are important or connected to the West find it easier to secure funding from the Paris Club or the IMF; those with more ties to China or the Gulf may seek their funding from Beijing, Riyadh or the United Arab Emirates.

Emerging markets are adapting to this new reality with strategies and policy sets that vary over time as much as they vary between countries, which pick and choose parts of the various economic models on offer. Some are moving toward orthodoxy in monetary and fiscal policy; others are widening imbalances by shirking. Elections can drive these changes, but now they can also move countries along a spectrum that runs from liberal democracy to strongman democracy to autocracy. And while many governments are pursuing nationalization or increased state involvement in strategic sectors, there are notable counterexamples: Egypt is currently privatizing and selling many former state assets to foreign partners; while Argentina has launched a radical liberal experiment. Finally, changing global trade patterns are pushing some countries toward greater mercantilism and others to try to support domestic demand.

An evolved economic paradigm requires an evolved investment process

The underlying economic and political context of emerging market countries profoundly affect the structural sources of alpha provided by EM asset markets. In the new paradigm where the opportunities available are greater than ever before, where the economic and political choices of countries are changing, and where outcomes are highly dispersed, one needs a new set of principles. Adding to this mix, EM investors have to adapt to a market structure in which benchmarked and indexed funds have largely replaced investors with an active mandate.

So what does this mean for an EM investment process? First, that there is still plenty of structural alpha available: investment processes need to be able to diversify across a large number of marketable EM assets and strategies to maximize investor returns and minimize risk. Second, this agility and flexibility is now key: managers must embrace the upsides and downsides of allocations and view capital allocations to countries and assets as temporary rather than structural. And third, value is no longer the proper anchor for investment decisions: passive money has no consideration for value, meaning assets can stay “rich” or “cheap” for years (consider Indian tech vs. banks Chinese) – but intense passive flows can also create large temporary dislocations that offer rich opportunities.

The framework above is completely foreign to the one that dominated the golden age. Requires considerable evolution of EM-focused managers; however we believe that for those who have demonstrated such evolution, EM offers incredible breadth and depth with precious little competition.

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Bradley Wickens is Founder, CIO and CEO at Extensive investment management