There is also the prospect for broadening of the emerging market opportunity set. The recent surge in commodity and oil prices has lifted optimism about economic prospects in the large natural resource producers in Latin America and the Middle East. Although this may not signal the start of another commodity super cycle, it does boost the near-term outlook for the cyclical regions and sectors of emerging markets.
Overcoming home bias
Like most global investors, Australians are still prone to home bias (a preference for the familiar - whether it be stock markets or individual companies).
For decades, Australian investors have been missing an opportunity to earn higher risk-adjusted returns by allocating too little of their portfolios to international equities.
But the likelihood of savvy global investors shunning markets far from home is likely to fall over time, particularly as the yields available on defensive assets like cash and bonds remain close to historic lows.
As emerging markets continue to gain share in global gross domestic product and global market capitalisation, and advance in financial depth and sophistication, they will become more attractive.
Given the long-run outlook for the world’s reserve currency, the United States dollar, we think generally that EM portfolio allocations are still too low.
EM equities tend to do better in a weaker dollar environment (see chart below). A weaker dollar leads to easier financial conditions and attracts foreign capital into emerging markets.
Conversely, as the dollar strengthens, emerging markets experience capital outflows and weaker returns for US investors - the world’s deepest and most sophisticated capital market.
The dollar has been trading up and down in the past few months, as longer-dated US government bond yields rose. But the fundamental factors for a longer-term trend of a weaker dollar continue — massive money printing, a huge fiscal deficit, and broadening global growth.
A weaker dollar could lift emerging market equities further. Australian investors can get ahead of any structural weakening of the US dollar and subsequent international capital flows by allocating to EM assets today.