Emerging market investmentsCurrent developments and long-term prospects

Research Insights – November 2018

Key messages

� Investments in emerging markets have performed

disappointingly so far in 2018.

� The high external vulnerability of individual countries has

proved to be their downfall. Concerns about contagion

to other emerging economies have led to a broad sell-off

of emerging market assets. However, these concerns

are likely to be exaggerated, as most emerging markets

remain fundamentally sound.

� Once investor concerns are at ease and their focus

again shifts to fundamentals, emerging market assets

will recover.

� Therefore, investors should not lose sight of the fact that

the long-term structural and fundamental conditions for

investments in emerging markets remain largely positive,

despite the current disappointing market trend.

� Emerging markets are economically speaking

underrepresented in global market indices. Therefore, the

Princely Strategy’s regional allocation is based primarily

on the risk/return profile of investments, using various

macroeconomic scenarios rather than global benchmarks.

� Depending on the environment, the Princely Strategy›s

allocation to emerging markets within equities, bonds and

private markets may change over time. Irrespective of this,

emerging market investments form an important anchor

for the long-term asset allocation of the Princely Strategy.

� Given the wide variety of emerging markets and the

increased political and institutional risks, we believe that

active implementation in these asset classes is essential in

order to reduce the risk of loss and to benefit from local

specialist knowledge.

Cov

er: F

loat

ing

Mar

ket

Bang

kok

Tour

, Tha

iland

Contents

4 Introduction

6 Fundamental data indicate an overreaction

7 Long-term growth drivers remain intact

8 Political and structural challenges raise the level of uncertainty

10 Underrepresented in benchmark indices

11 Emerging market investments as part of the Princely Strategy

12 Focus on local currency bonds

14 Focus on hard currency bonds

16 Focus on emerging market equities

18 Summary

Introduction

The past few years have proved challenging for a wide

range of investment strategies, styles, classes and regions,

including emerging market investments. While they initially

recovered relatively quickly in the wake of the largest financial

crisis of the post-war period, they have since been exposed to

periodic headwinds.

However, it is precisely when an investment is trending

well below long-term expectations that negative reports,

commentaries and analyses tend to appear. In such situations,

it is often difficult to tune out the noise and take an objective

view instead.

This holds true not only for the tactical positioning, which is

the immediate attractiveness of the investments against the

backdrop of the cyclical economy and the political environment.

In addition, it is especially important in regards to long-term

asset allocation. The focus here is on the fundamental value

drivers of an investment and its characteristics in the context of

the overall portfolio.

Drivers of the disappointing performance in 2018

2018 has proved to be particularly challenging for investments

in emerging markets (EM), as investors have suffered significant

losses on their equity and bond investments.

� EM hard-currency bonds are predominantly denominated

in US dollars and have therefore suffered from the rising

US yield curve and an increase in the risk premiums of the

index heavyweights Argentina, Turkey and Venezuela, whose

credit spreads rose by more than ten percentage points in the

course of the year.

� EM local currency bonds were on average neutral in their

respective local currencies, thereby investors only suffered

losses on the currency side. Currencies depreciated against

the euro by around 4.5%. Since the greenback rose at

the same time, the loss from a US dollar perspective is

significantly higher.

� Equity investments in emerging markets suffered the most,

due to lower earnings expectations, a correction in valuations

and currency losses.

1 Period considered: December 31, 2017 to October 31, 2018. Indices: JPM EMBI Global (hedged), JPM GBI-EM Global Diversified, MSCI Emerging Markets (NR). The index for hard currency bonds is hedged against the US dollar and euro. The return in euros, which was around two percentage points lower, stems from the costs of currency hedging from the US dollar to the euro.

Performance of emerging market investments

(January to October 2018)1

Source: LGT Capital Partners, Thomson Reuters

-5.6%

-9.9%

-15.7%

-7.9%

-4.6%

-10.7%

-20%

-15%

-10%

-5%

0%

EM hardcurrency bonds

EM localcurrency bonds EM equities

in USD in EUR

4

The main causes for the negative performance of the

investments are not only to be found in the emerging

markets, however also in the US. Firstly, the trade conflict

between the US and China intensified over the course of the

year. Thus, there was an increase in investor uncertainty about

US trade policy and the geopolitical situation, which led to a

rise in risk premiums and a correction in the valuations of EM

investments. Chinese companies related to the US economy

and the technology sector, which are directly affected by

President Trump’s measures, were hit particularly hard.

Secondly, the stronger than originally anticipated US economy

has caused the Fed to steadily tighten monetary policy, leading

to rising interest rates and a strong US dollar. Both of these

factors make it difficult to service USD-denominated debt, which

is why countries, such as Argentina, Turkey and South Africa,

with high external financing needs, came under pressure. Lastly,

the price of oil has risen by over 30% since mid-2017, which

has additionally burdened the current account balances of net

oil importers, such as India and Turkey.

The implications of US monetary policy for the development

of emerging markets is currently the subject of controversial

debate among analysts. Although it is undisputed that the

global tightening of monetary policy, which is driven by

interest rate hikes by the US Federal Reserve, makes refinancing

conditions in emerging markets more difficult, opinions differ

as to whether this will inevitably lead to crisis-like developments

in the emerging markets with the weakest fundamentals in a

domino movement, or whether the crisis-like developments of

recent months in Argentina and Turkey can be traced back to

country-specific undesirable developments.

We believe that Argentina’s balance of payments crisis

and Turkey’s sharp currency devaluation are not due to

US monetary and trade policy, but rather to negative local

developments. Turkish President Recep Erdogan, for instance,

is reacting in an increasingly authoritarian manner and exerting

greater pressure on local institutions such as the central bank,

whose independence is in question. In addition, the political

conflict with the US government, which resulted in sanctions

against Turkey, had a negative impact. In Argentina, the

central bank’s decision towards the end of 2017 to tolerate a

higher inflation rate in the future undermined the still fragile

confidence of the local population and investors, which lead

to a flight from the peso.

Worried that these local problems could also cause issues for

other emerging markets and ultimately lead to a similar kind

of repetition to the Asian crisis of the late 1990s, international

investors have taken the precautionary approach of reducing

positions, and thus are putting pressure on other currencies

in the process. Falling currencies and rising energy prices have

increased inflationary pressure in many emerging markets,

prompting central banks to make precautionary interest rate

moves, as seen in India, Indonesia, Russia and Mexico. However,

this response from the central banks, exemplary as it might

seem, has created additional uncertainty in some places, since

some market participants viewed this as confirmation of their

fears of a spreading currency crisis. Furthermore, in Asia, there

were rising concerns over second-round effects from the

US-Chinese trade conflict, which could also impact smaller

countries that are highly dependent on China due to the export

channel and the cross-border value chains. As a result, emerging

market investments, from equities to credit and bonds,

corrected sharply in the third quarter of the year.

5

Fundamental data indicate an overreaction

The fact that the correction was so sharp is among others

due to the investor structure, which has changed significantly

over the past decade. The zero interest rate and QE policies

seen around the globe have pushed investors into riskier

markets where they have limited experience, such as into

emerging market investments. As the negative news from

emerging markets has accumulated over the year, many of

these rather tactically oriented investors fled back to their

known markets. Since these investors mainly use passive

instruments such as ETFs, they were relatively indiscriminate in

their selling, thereby punishing not only the weaker countries,

but the entire region. Thus, individual fundamental issues that

were unique to one country ultimately resulted in a systematic

punishment of emerging market investments in general. This

is also consistent with the current extremely negative investor

sentiment, which we recently experienced ourselves at the

IMF’s autumn meeting and which has been confirmed in a

wide range of surveys among investors and asset managers.

As long-term investor, we must distinguish between a contagion

of prices and a contagion of underlying fundamentals. However,

we believe that the latter is not the case. On the contrary, the

emerging markets are performing better today than they were

during past crises, such as during the Tequila crisis or the Asian

crisis. Furthermore, they have continued to improve over the last

few years. In addition, external conditions as a whole remain

positive for emerging markets. Global expansion is continuing

despite a modest slowdown, and commodity prices have

stabilized again following the major correction in 2014/2015.

Not a typical emerging market crisis

Historically, most emerging market crises (Latin American crisis

1982, Tequila crisis 1994, Asian crisis 1997/1998) have been

triggered by imbalances in the balance of payments. Such crises

typically emerged due to the currencies’ peg to the US dollar,

governments and private individuals being able to borrow

excessively in cheap short-term foreign currency loans, consume

beyond their means and thus drive the domestic economic

boom. Loans and debt service were denominated in US dollars,

however investments and income were denominated in local

currency. External debt and exchange rate risks increased,

while trade balances lagged. In certain instances, –such as

when triggered by an economic slowdown, political crises

or rising US interest rates, the sustainability of the currency

peg was questioned, and the pressure on the balance of

payments increased. Foreign exchange reserves revealed to be

disproportionately small and unable to support the currency over

the long run, and central banks were forced to sharply devalue

their currencies. Hidden exchange rate risks now materialized,

which makes it impossible to service foreign debt, and often

leads to a combined currency, bank and sovereign debt crisis.

These crises cannot be compared with the current situation in

the emerging markets. As firstly, the vast majority of emerging

markets today have flexible exchange rates, which means that

it is not possible to accumulate foreign exchange risk to the

same extent. The currencies assume the function of a buffer,

thereby excessive pressure does not accumulate in the balance

of payments, however can escape via a currency devaluation.

The associated currency losses are hard to digest for investors,

however in return the risk of payment defaults or local financial

crises is ultimately reduced. Secondly, emerging markets are

currently also borrowing abroad. However, mainly in their

domestic currency rather than in hard currencies, such as

the US dollar or the euro, which reduces exchange rate risks

on borrowers’ balance sheets. Third, a large part of foreign

currency debt today is held by commodity companies, which

also generate their revenue in US dollars. In addition, emerging

markets currently have significantly higher and adequate foreign

exchange reserves. Lastly, trade balances are more stable.

2 Emerging markets excluding China, weighted according to GDP adjusted for purchasing power.

10%

20%

30%

40%

50%

0%

5%

10%

15%

20%

25%

1980 1985 1990 1995 2000 2005 2010 2015 2020

FX reserves (% of GDP)

External debt (% of GDP) – rhs

Source: LGT Capital Partners AG, Oxford Economics

Foreign currency reserves and foreign debt2

6

Furthermore, long-term growth forecasts anticipate higher

growth in the emerging markets in the coming years, as their

structural growth drivers remain intact. Emerging economies are

benefiting from the “demographic dividend.” Positive overall

population growth and a supportive age structure will allow the

working age population to continue to grow strongly over the

coming decades, while in the industrialized countries this figure

has been declining since 2015.

In addition, emerging economies have a higher rate of

productivity growth. Specifically, not only is the number of

workers increasing, however also their output. They benefit,

for instance, from rising levels of education, the implementation

of economic reforms, the expansion of infrastructure and

increasing urbanization. This is because the population

concentration associated with urbanization results increased

efficiency and economies of scale, such as in infrastructure and

logistics. However, the greatest productivity increases are based

on technological progress. In the past, this was mainly through

the adaptation of technologies from industrialized countries.

Today, it is also through their own research and development

in high-tech areas, such as robotics, biotechnology or artificial

intelligence. With the rising prosperity of the population, an

increase in the average propensity to consume can also be

observed, which is causing the consumer sector in particular to

grow disproportionately. In other words, emerging economies

will continue to create a large amount of value over the coming

decades. This will undoubtedly create various opportunities for

companies and investors.

Long-term growth drivers remain intact

Source: LGT Capital Partners, United Nations Population Division

3 Industrialized countries: More developed regions; emerging markets: Less developed regions, excluding least developed countries; working age: 15 to 69.

Source: LGT Capital Partners, United Nations Population Division

Working-age population (in millions)3

0

1 000

2 000

3 000

4 000

5 000

1980 1990 2000 2010 2020 2030 2040

Developed countries Emerging countries

Annual growth rate

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

1980 1990 2000 2010 2020 2030 2040

Developed countries Emerging countries

Source: LGT Capital Partners, Oxford Economics

Productivity growth (per employee, annualized)

0%

2%

4%

6%

8%

10%

US

Gre

at B

rita

in

Ger

man

y

Fran

ce

Jap

an

Ital

y

Chi

na

Ind

ia

Ind

on

esia

Pola

nd

Sou

th K

ore

a

Russ

ia

Bra

zil

Sou

th A

fric

a

Mex

ico

2000 to 2018 2018 to 2030 (Estimate)

77

Political and structural challenges raise the level of uncertainty

Parallel to the excellent long-term growth prospects, emerging

markets may face numerous challenges over the next few years.

An instance of such is that in various places, necessary structural

reforms must be introduced or continued. Yet, many of these

reforms are unpleasant in the short to medium term for the

electorate, who could punish the ruling government in the next

elections, which particularly applies to Latin America. In Mexico,

the new left-wing government wishes to reverse the reforms

of recent years. In Argentina, President Mauricio Macri must

lead the country out of the balance of payments crisis through

unpleasant policies, while at the same time, securing the favor

of voters for the elections in 2019. Furthermore in Brazil, the

new government must illustrate that they can continue the

structural reforms that have begun and secure the stabilization

of public finances.

Moreover, the specter of populism is spreading not only to

mature democracies, such as the US or Europe, where control

mechanisms have been established to limit its dangers. Yet,

populism is also rampant in various politically less stable

emerging countries such as Brazil, Turkey, the Philippines

and South Africa. This is endangering not only liberal values,

however also the status and protection of international

investors. These political risks have been neglected in recent

years, due to the oversupply of liquidity to the global economy

and financial markets. In this respect, an increase in premiums

is certainly justified.

In China, the government is working on restructuring

the economy. The emphasis is on shifting the focus from

government investments to private consumption, while

simultaneously increasing financial stability, reducing harmful

emissions and modernizing domestic industry. However, as with

all structural reforms, the costs are immediate and it may take

several years for an impact to become apparent. China’s reforms

are undoubtedly positive in the long-term, however economic

growth will slow down during the reform and transformation

phase, which may have a negative impact on other emerging

economies in the medium term. In addition, it is rather

difficult to restructure the Chinese economy. However, we

assume that this will ultimately succeed, despite the chance

that some obstacles may be present. This assumption is due to

the fact that the Chinese government has the will, the means

and the experience to do so. Yet, an accident in the form of a

hard landing for the Chinese economy cannot be completely

ruled out.

In addition, the US-Chinese conflict will prevail. The dispute is

only superficially about tariffs, which are low and will remain

low in the event of a significant increase compared to China’s

economic strength and can be mitigated with appropriate

countermeasures. Moreover, both parties have no interest in

a dramatic escalation. Rather, the dispute must be seen in a

broader geostrategic context. The US, the de facto sole world

power since the collapse of the Soviet Union, will be challenged

8

over the coming years by emerging China both economically

and geopolitically, as well as, militarily. China’s leadership relies

on state capitalism and protects key industries by restricting

access to markets or imposing the transfer of know-how on

foreign firms. US President Donald Trump wants his trade tariffs

to force China to make concessions in industrial policy, thereby

demanding reciprocity and slowing China’s rise. In addition,

the US is increasingly demonstrating its military strength in the

South China Sea, where mutual provocations between the two

military forces regularly take place and thus increases the chance

for an accidental escalation. We expect the US-Chinese rivalry to

intensify over the coming years.

However, there are also challenges present in the industrialized

countries. Technological advances in the fields of automation,

robotics and artificial intelligence have the potential to

significantly increase productivity and growth in industrialized

countries over the next decade. For example, the new

technologies will allow a partial relocation of production steps

from locations with cheap labor, such as emerging economies

to industrialized countries. The consulting firm McKinsey, for

instance, estimates that the introduction and widespread use

of artificial intelligence in industrialized countries could make

a positive contribution to growth of around 1.5 percentage

points.4 This would partly undermine relative advantages of

emerging economies, such as cheap labor or higher structural

growth. In addition, protectionist US trade policy is one of the

factors that is promoting this technology-driven shift back to

industrialized countries.

In the medium term, global value chains could be somewhat

disrupted and become more strongly regionally oriented, which

in some places could also lead to less dependence on the US

or European economy. Another possible consequence could be

that today’s highly globalized world increasingly forms regional

geostrategic and trade blocs, such as around the US, Europe,

Russia and China. Signs of this movement have been observed

for some time, particularly in Asia. In Southeast Asia, for

instance, the ASEAN states and China created the world’s largest

free-trade zone around 10 years ago, with a population of over

1.9 billion. With its new Silk Road initiative (also known as “One

belt, one road”), China is building a gigantic intercontinental

trade and infrastructure network that extends by sea and land

from China via Central Asia and the Middle East to Europe. The

Chinese “belt” is to be understood as a two-pronged strategy.

It is considered to be a charm offensive on its southwestern

neighbors, however also as a means of further consolidating

economic and geopolitical influence on neighboring countries.

4 McKinsey Global Institute, September 2018, “Notes from the AI frontier: Modeling the impact of AI on the world economy”.

99

How should the weighting of emerging market assets in

strategic asset allocation be determined? Many investors

are surprisingly unfamiliar with questions regarding regional

allocation. Instead, their allocation is similar to that of widely

used benchmark indices, thereby delegating the decision to

these benchmarks. The logic behind this is that if you follow

these indices in your investments, it is similar to investing in

the overall market and therefore you can’t go “wrong.” This is

despite the fact that most investors are aware of the pitfalls of

these benchmarks.5

Emerging markets typically compose a small portion of

these benchmark indices. The reasons for this being the lower

proportion of companies that are listed on the stock exchange

and instead are held privately, or the exclusion criteria of index

providers with regard to market access and liquidity, or possible

capital controls. Their low weighting in global indices contrasts

sharply with the high economic and geopolitical weight of

emerging markets. Although emerging markets represent

around 85% of the global population and 40% of global

value added, they account for only around 5% to 10% of the

weighting in global equity and bond indices. In other words,

emerging markets are significantly underrepresented in global

market indices.

For investors the focus is not on today’s economic strength,

however on how it will develop going forward. Over the next

decade, more than half of global growth will be generated in

the emerging markets with various forecasts even stating that

it could be up to two-thirds. Yet, investing based on global

indices would mean an allocation of only about 10% of capital

to this region and as a result only marginal benefits from this

substantial contribution to growth.

However, emerging markets are also gaining in importance

beyond GDP statistics, as they are playing an increasingly

important geopolitical role. In 2005, the G7 summit was

expanded to include the most important emerging countries

and was replaced in 2008 by the G20, half of which are

emerging countries. China tops the list, as it grows more

confident in its foreign policy. Over the next two decades,

China will increasingly challenge the position of the US, as the

undisputed global superpower.

Index providers decide on the inclusion or reclassification of

markets in regular reviews. The share of emerging markets in

the global indices will therefore continue to grow due to the

increasing openness of their capital markets, better access for

international investors and greater liquidity of investments. In

particular, China and India will have a greater weighting in the

global indices. However, these adjustments are mainly based

on technical aspects and from an economic point of view, are

perceived only after a long delay. According to the MSCI, South

Korea is still considered an emerging country, even though it has

a higher per capita income than countries such as, Spain or Italy

(on a PPP-adjusted basis).

Therefore, similar to the Princely Family, other long-term

investors should not base their asset allocation primarily on

global benchmark indices, rather they should base them on

an assessment of the risk-return profile of asset classes in the

context of their own risk profile.

5 On the equity side, for example, companies are weighted on the basis of their market capitalization, with an overvalued company receiving a comparatively higher weighting and companies or regions with cheaper valuations receiving a lower allocation, despite the associated better long-term return prospects. On the bond side, the greater the debt, the greater the weighting and capital an issuer receives. Indices, therefore, tend to “reward” a higher price or loss risk with a greater allocation. From an investor point of view, such strategies are not worthwhile.

Underrepresented in benchmark indices

Importance of emerging markets based on population, value

creation and benchmarks

Source: LGT Capital Partners, UNO, Oxford Economics, MSCI AC World, JPM GBI Global, JPM

GBI-EM Global

5% 11%40%

66%86% 95%

0%

20%

40%

60%

80%

100%

Governmentbonds

Equities 2018 Growthshare until 2030

2018 Growthshare until

2030

Global capitalmarkets

Global economicactivity

(GDP in USD)

Global population

Emerging and developing economies Advanced economies

10

Since their inception some 20 years ago, investments in

emerging markets have been an integral part of the strategic

asset allocation of the Princely Strategy. In the global bond

segment, a substantial portion is invested in hard and local

currency bonds from emerging markets. Both offer attractive

interest rates that substantially offset the inherent risk of loss in

the long-term. As for equities, emerging markets are weighted

significantly higher than in typical global equity indices, in line

with their economic importance. In addition to investments

in public markets, the Princely Strategy is also increasingly

investing in emerging markets in the private markets area. The

weighting of the emerging markets in the individual areas is not

determined by benchmark weighting or market capitalization,

however by their long-term risk-return outlook and taking into

account various macroeconomic scenarios.

Yet, this does not mean that the Princely Strategy always keeps

its allocation to emerging market investments at the same level.

Since the returns on emerging market investments fluctuate

much more than the returns on global equities or government

bonds, they can also suffer longer periods of drought, despite

their attractive long-term return prospects. Conversely, emerging

market investments can also outperform their long-term

expectations if there is a corresponding tailwind from the cyclical

side and external factors. These phases can last a few months,

as well as, several quarters. Therefore, the Princely Strategy

makes adjustments on occasion to its tactical positioning and

to its strategic allocation to emerging market investments in

line with the short- to mid-term assessment of the political and

economic outlook and the market situation.

Active implementation particularly important

for emerging market investments

In our view, active implementation is indispensable when

investing in emerging markets. Firstly, the label “emerging

economies” refers to a diverse group of countries that differ

far more from each other than industrialized countries, in

terms of the form of government, economic structure, trading

partners, governance, legal system and level of prosperity.

Therefore, global cyclical factors, such as interest rates or

economic momentum, affect the individual emerging markets

and their companies extremely different in some cases. However

geopolitical developments, such as the US-Chinese trade

dispute or structural trends, also showcases clear winners and

losers at the country, sector and company level. In addition,

the capital markets in emerging countries are widely regarded

as less efficient than in industrialized countries, partly due to

the much lower coverage by analysts. This results in attractive

opportunities for active investors.

In addition, an active investment approach can help to reduce

the greater risks of emerging market investments. This applies,

however, much less to price volatility, as it does to the risk of

permanent losses on individual investments that can occur, such

as through inadequate corporate governance, capital controls,

state influence or expropriation of investors and nationalization

of strategically important companies. Such considerations are

alien to many investors in industrialized countries, however

in the case of emerging markets, they can make a significant

contribution to the success or failure of investments.

As emerging markets have various political, legal and economic

unknowns, it is all the more vital that investment decisions are

not made in relation to the past, as is the case with passive,

index-replicating investments, however actively with an outlook

towards the future and risks of the individual investments.

Therefore, the Princely Strategy makes all its investments

in emerging markets, both in bonds and equities, through

specialized internal or external managers, who often have a

local presence in the respective markets and thus have vital local

expertise and extensive networks in the region in relation to the

politics and the economy.

Emerging market investments as part of the Princely Strategy

1111

Focus on local currency bonds

Local currency bonds are attractive as long-term investments,

mainly due to their carry. The performance of this asset class

is determined by three components: (1) interest rates, (2)

price change of the bonds in local currency and (3) currency

developments. The short-term performance or fluctuation is

mainly determined by the currency development, which still

holds true in 2018. However, as the following graph shows, the

interest contribution clearly dominates over the long-term. In

contrast, the contribution from the price performance of local

bonds has only been slightly positive, while the contribution

from currencies has been negative.

However, investors who wish to benefit from these attractive

interest rates must also take into account the exchange rate

risk. Therefore, the higher interest rates can also be regarded as

a premium for having to endure these currency fluctuations.7

The attractiveness of this premium for international investors

is determined by two following components: the level of the

premium and the currency risk it entails.

6 JPM GBI-EM Global Diversified (in USD). Period considered: October 31, 2003 to October 13, 2018 (15 years).7 The costs of hedging the individual currency risks corresponds approximately to the difference between the money market rate of the base currency and the money market rate of the respective currency. In order to hedge the currency risk, the interest rate advantage must therefore be waived.

Long-term return drivers6

Source: LGT Capital Partners, JP Morgan

50

100

150

200

250

300

350

2003 2006 2009 2012 2015 2018

Total return in USD Interest

Bond prices Currencies

Return contributions (in USD, annualized)6

Source: LGT Capital Partners, JP Morgan

6.6%

1.5%

-2.1%

5.9%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

9.0%

8.0%

Interest Bond prices Currencies Total return

12

1) The amount of the premium that an investor receives when

investing in emerging market local currency bonds instead of

domestic government bonds is reflected in the interest rate

difference between the two investments. Typically, not nominal,

however real returns are compared.8 This difference in real

interest rates is currently regarded as very attractive. Compared

to real interest rates in industrialized countries, which remain at

around 0%, real interest rates in emerging markets are around

3.5%. Thus, the premium on local currency bonds is at its

highest level since the financial crisis.

2) Assessing the currency risk is more challenging. The focus

is on vulnerability and valuation. As described above, most

emerging markets today are generally less vulnerable than in

1996 or 2007, with the exception of Argentina, Venezuela,

Turkey and South Africa, due to adequate currency reserves

and healthy basic balances. As a result, the probability of a

broad balance of payments crisis in the emerging markets can

be classified as low. In addition, emerging market currencies

are very favorably valued following the sharp correction in the

second half of 2018. This means that the potential for further

devaluations is rather low. In fact, investors should be able to

benefit from the currencies approaching their fair value again in

the upcoming years.

In short, local currency bonds offer an attractive source of

return, due to their high interest rates. However, these bonds

are at times associated with strong currency fluctuations. The

short-term total return of the asset class is, therefore, mainly

driven by currency trends. However, the longer the investment

horizon, the more dominant the influence of the interest

component, the carry. In addition, the asset class is currently

attractively valued, both in terms of the interest rate advantage

and the currency valuation.

8 The principle of purchasing power parity states that currency parities change according to differences in inflation. A higher rate of inflation in one currency i against another currency j is offset by a corresponding devaluation of currency i against j. Consequently, investors with base currency j cannot benefit from higher nominal interest rates in currency i insofar, as these are attributable to different inflation rates. Either the currency i depreciates, or its valuation increases and so does the risk.9 Industrialized countries: JPM GBI 7-10Y less inflation, GDP-weighted average from US, UK, Japan and EMU; emerging markets: JPM GBI-EM Gl. Div. less inflation, index-weighted average from Brazil, Indonesia, Colombia, Malaysia, Mexico, Peru, Poland, Romania, Russia, South Africa, Thailand, Czech Republic, Turkey and Hungary.

Source: LGT Capital Partners, JP Morgan, Thomson Reuters

Real interest rates on government bonds9

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

2008 2010 2012 2014 2016 2018

Real interest rate differential

Developed countries Emerging countries

Valuation of emerging market currencies against the USD

Source: LGT Capital Partners, Goldman Sachs, JP Morgan

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

2000 2003 2006 2009 2012 2015 2018

Overvalued

Undervalued

1313

Focus on hard currency bonds

In contrast to local currency bonds, hard currency bonds are

typically issued in US dollars, however increasingly also in euros.

These investments do not involve any direct currency risk for

investors. In return, investors bear an increased risk of default.10

A premium is paid to compensate investors for bearing the risk

that there will be more defaults than expected and for other

risks, such as potential illiquidity in times of stress or increased

volatility.11 Since the premiums on hard currency bonds are

usually significantly higher than the actual future defaults,

investors who invest in EM hard currency bonds instead of safe

government bonds can achieve an additional return over the

long run.

Historically, default rates for emerging market governments

have averaged around 0.8% per year.12 With a recovery rate of

around 40%, this results in an expected annual default loss of

only around 0.5%, while premiums over the past 20 years have

averaged around 4.5%. In the long-term, investors will clearly

benefit from an allocation to hard currency bonds.

10 If a government issues bonds in its local currency (local currency bonds), it can repay them at any time by printing its own currency. Investors, therefore, bear the devaluation or currency risk. However, if a government issues bonds in hard currency, there is a risk that it will no longer be able to service these debts in the future, or only partially. Thus, investors bear the default risk. However, both risks are closely linked. If a currency depreciates sharply, servicing debts in hard currency becomes more difficult and the risk of default rises accordingly.11 The premium is usually set from the credit spreads. The credit spread is the difference between the yield of a bond and the yield of risk-free bonds of the same duration and base currency, such as US Treasuries or German Bunds.12 Moody’s (2016), “Sovereign Default and Recovery Rates, 1983-2015.”13 Period considered: October 31, 1998 to October 13, 2018 (20 years). Global government bonds: FTSE World Government Bond Index (hedged in USD); hard currency bonds: JPM EMBI Global (in USD).14 JPM EMBI Global (in USD). Period considered: October 31, 1998 to October 13, 2018 (20 years).

Performance of bond indices (in USD)13

Source: LGT Capital Partners, FTSE, JP Morgan, Thomson Reuters

+132%

+478%

0

100

200

300

400

500

600

700

10/1998 10/2003 10/2008 10/2013 10/2018

Global government bonds Hard currency bonds Source: LGT Capital Partners, JP Morgan, Thomson Reuters

Return contributions (in USD, annualized)14

2.7%

2.4%

4.1% 9.2%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

Cash Duration EM premium Total return

14

The premium on hard currency bonds has risen significantly

since the beginning of 2018, amounting to around 4% at the

end of October 2018. Not only is it higher than the average

for the past 15 years, it is also significantly higher than the

premium, for example, on US corporate bonds, with US

corporate leverage currently close to an all-time high. In our

view, this reflects a mispricing of hard currency bonds based on

excessive pessimism towards emerging markets. Some market

participants are unwilling to invest in the asset class, as they

fear short-term price losses, due to the heightened uncertainty.

However, long-term investors who are willing to bear such

short-term price risks can benefit from the attractive premiums

in this asset class.

The Princely Strategy benefits from the premiums on hard-

currency bonds not only through its strategic allocation to the

asset class, however also through countercyclical purchases in

the event of major upheavals, such as in February 2016.

15 JPM EMBI Global (stripped spread, in basis points), capped at 600 basis points.16 Hard-currency bonds: 50% JPM EMBI Global BBB Rated (stripped spread), 50% JPM EMBI Global BB Rated (stripped spread). US corporate bonds: 50% ICE BofA/ML BBB US Corporate Index (OAS), 50% ICE BofA/ML BB US Corporate Index (OAS). Capped at 600 basis points.

Credit premium on hard currency bonds15

100

200

300

400

500

600

10/2003 10/2006 10/2009 10/2012 10/2015 10/2018

Credit spread Median

Comparison of risk premiums of the same quality16

Source: LGT Capital Partners, JP Morgan, BofA/ML, Thomson Reuters

10/2004 04/2008 10/2011 04/2015 10/2018

EM hard currency bonds US corporate bonds

100

200

300

400

500

600

1515

Emerging market equities are particularly well-placed to benefit

directly from the strong economic growth of emerging markets.

Over the past 20 years, the MSCI Emerging Markets index has

outperformed by more than a factor of two its counterpart

from the industrialized countries, the MSCI World. The main

drivers of this performance were corporate earnings growth

and dividends, while the valuation (price/earnings ratio) and

currencies made a slightly negative contribution.17

However, higher long-term returns also go hand in hand with

greater risks. For instance, emerging market equities are typically

much more volatile than equities from the US or Japan. In

addition, investors who want to profit from the long-term excess

returns of the asset class must also reckon with longer dry spells.

Emerging market equities are often mistakenly considered to

be highly sensitive to commodity prices. From a fundamental

point of view, this was certainly partly justified in the past. The

share of commodity companies in the MSCI Emerging Markets

Index was around 30% between 2004 and 2011. However,

over the past few years, their share has been cut roughly in

half, while companies in the consumer and technology sectors

now account for over 40% of the total index. As a result,

emerging market returns are no longer driven by commodity

prices, however they are much more dependent on domestic

developments.

Focus on emerging market equities

17 As with local currency bonds, equity investments in emerging markets are typically not hedged against currency risk. In some currencies there are no suitable instruments for currency hedging, while in some currencies the costs are excessively high. 18 MSCI World (TR in USD) and MSCI Emerging Markets (TR in USD). Period considered: October 31, 1998 to October 13, 2018 (20 years).19 MSCI Emerging Markets (TR, in USD, annualized). Period considered: October 31, 1998 to October 13, 2018 (20 years).

Performance of equity markets (in USD, total return)18

Source: LGT Capital Partners, MSCI

+210%

+474%

0

100

200

300

400

500

600

700

800

10/1998 10/2002 10/2006 10/2010 10/2014 10/2018

MSCI World MSCI Emerging Markets

Return contributions (in USD, annualized)19

Source: LGT Capital Partners, MSCI

0%

5%

10%

15%

20%

25%

30%

DividendsEarnings growth

ValuationCurrencies

Total return

6%

21%

-4%

-3%

19%

16

As can be seen above, the performance of equity investments

is mainly based on earnings growth and dividends, and only to

a small extent on valuation. On the other hand, for a somewhat

shorter period of about five years, the valuation of stock

markets can be a major driver of returns, especially if it is very

expensive or very cheap.

Emerging market equities have undergone a significant

valuation adjustment since 2011. Measured by common

multiples, they are currently trading at a discount of around

30% to their industrialized counterparts. This is despite the fact

that the return on equity has been on an upward trend for two

years and is at the same level as that found in the industrialized

countries. We expect this valuation discount to normalize

at least in part over the coming years and emerging market

equities to outperform the global equity index.

Valuation of MSCI EM relative to MSCI World

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

10/2003 10/2006 10/2009 10/2012 10/2015 10/2018

Price/earningsPrice/fwd EPSPrice/book

Source: LGT Capital Partners, MSCI

Composition of the MSCI EM: Commodity companies and

technology/consumer

0%

10%

20%

30%

40%

50%

1998 2002 2006 2010 2014 2018

Commodity sectors (energy and materials)

IT and consumer

1717

Summary

In some countries, there were undoubtedly some justified,

specific reasons for the negative performance. However, we

consider the fundamentals of most emerging markets to be

robust. Therefore, we hold the view that the majority of the

negative development is attributable to a change in sentiment

among international investors. The main reasons for this are

likely to be the harsh US trade policy, a rise in geopolitical

uncertainty and concerns about an excessive tightening of US

monetary policy. As investor concerns ease and the focus once

again shifts to fundamentals, emerging market assets are likely

to recover. This is because the structural growth drivers and the

drivers of long-term investment returns for stocks and bonds

in emerging countries remain intact, while developed countries

offer only subdued growth and low yield prospects.

Emerging economies will continue to be the main contributor of

global growth over the coming years, resulting in a wide range

of attractive long-term investment opportunities. Therefore,

emerging market investments are a vital anchor for the strategic

asset allocation of the Princely Strategy. The weighting of these

investments is not based on prevalent benchmarks, but on the

long-term risk-return outlook for the investments and their

properties within the context of the portfolio. In view of the

political and structural challenges, however, the importance

of active investment decisions and active management of

investment risks in emerging markets has also increased. In

order to benefit from local specialist knowledge and to reduce

the risk of permanent losses, the Princely Strategy actively

implements all emerging market investments.

18

Important informationThis marketing material was issued by LGT Capital Part-ners Ltd., Schützenstrasse 6, CH-8808 Pfäffikon, Swit-zerland and/or its affiliates (hereafter “LGT CP”) with the greatest of care and to the best of its knowledge and belief. LGT CP provides no guarantee with regard to its content and completeness and does not accept any liability for losses which might arise from making use of this information. The opinions expressed in this marke-ting material are those of LGT CP at the time of writing and are subject to change at any time without notice. If nothing is indicated to the contrary, all figures are unau-dited. This marketing material is provided for informati-

on purposes only and is for the exclusive use of the reci-pient. It does not constitute an offer or a recommendation to buy or sell financial instruments or services and does not release the recipient from exercis-ing his/her own judgment. The recipient is in particular recommended to check that the information provided is in line with his/her own circumstances with regard to any legal, regulatory, tax or other consequences, if ne-cessary with the help of a professional advisor. This mar-keting material may not be reproduced either in part or in full without the written permission of LGT CP. It is not intended for persons who, due to their nationality, place of residence, or any other reason are not permitted ac-

cess to such information under local law. Neither this marketing material nor any copy thereof may be sent, taken into or distributed in the United States or to U. S. persons. Every investment involves risk, especially with regard to fluctuations in value and return. Investments in foreign currencies involve the additional risk that the foreign currency might lose value against the investor’s reference currency. It should be noted that historical re-turns and financial market scenarios are no guarantee of future performance.

© LGT Capital Partners 2018. All rights reserved.

LGT Capital Partners Ltd.Schuetzenstrasse 6CH-8808 PfaeffikonPhone +41 55 415 96 00Fax +41 55 415 96 99

LGT Capital Partners (USA) Inc.1133 Avenue of the AmericasNew York, NY 10036 Phone +1 212 336 06 50Fax +1 212 336 06 99

LGT Capital Partners (Ireland) Ltd.Third floor30 Herbert StreetDublin 2Phone +353 1 433 74 20Fax +353 1 433 74 25

LGT Capital Partners (U.K.) Ltd.1 St. James’s MarketLondon SW1Y4AHPhone +44 20 7484 2500Fax +44 20 7484 2599

LGT European Capital Ltd. 1 St. James’s MarketLondon SW1Y4AHPhone +44 20 7484 2500Fax +44 20 7484 2599

LGT European Capital Ltd.37 Avenue Pierre 1er de Serbie75008 ParisPhone +33 1 40 68 06 66Fax +33 1 40 68 06 88

LGT Capital Partners (FL) Ltd. Herrengasse 12 FL-9490 Vaduz Phone +423 235 25 25 Fax +423 235 25 00

LGT Capital Partners (Dubai) LimitedOffice 7, Level 3, Gate Village 10Dubai International Financial CentreP.O. Box 125115 Dubai, United Arab EmiratesPhone +971 4 401 9900 Fax +971 4 401 9991

LGT Investment Consulting (Beijing) Ltd.Suite 1516, 15th FloorChina World Tower 1No. 1 Jianguomenwai AvenueChaoyang DistrictBeijing, P.R. China 100004 Phone +86 10 6505 82250Fax +86 10 5737 2627

LGT Capital Partners (Asia-Pacific) Ltd.Suite 4203 Two Exchange Square8 Connaught PlaceP.O. Box 13398Central Hong Kong, HK Phone +852 2522 2900Fax +852 2522 8002

LGT Capital Partners (Japan) Co., Ltd.17th Floor Stage Building2-7-2 Fujimi, Chiyoda-ku102-0071 Tokyo Phone +81 3 6272 6442Fax +81 3 6272 6447

LGT Capital Partners (Australia) Pty Limited Level 36 Governor Phillip Tower 1 Farrer PlaceSydney NSW 2000 Phone +61 2 8823 3301

19

1118

2.5

H L

GT

LGT Capital Partners Ltd.Schuetzenstrasse 6, CH-8808 PfaeffikonPhone +41 55 415 96 00, lgt.cp@lgt.com

www.lgtcp.com