Emerging market equities have been typically unpredictable in 2021, but they are still important drivers of global growth, finds Andrew Holt.
Emerging markets made a strong start to the year, yet come the summer, many of those gains had been wiped out. This is a common theme in the volatile world of emerging market equities. Institutional investors are, therefore, approaching the asset class with caution.
According to BNP Paribas Asset Management, institutional investors globally are underweight emerging market equities: holding 7% compared to the 9% long-term average. “Investors need to think about their ideal positioning in emerging market equities by considering their return requirements and risk tolerance,” says Quang Nguyen, head of global emerging markets equities at BNP Paribas Asset Management.
Developing nation sovereigns and corporates deserve a meaningful allocation for long-term global institutional investors, such as pension funds, Nguyen says. “Despite volatility caused by the pandemic, there are a number of long-term structural shifts that support the investment case, including the demographic dividend, technology innovation and healthier balance sheets,” he adds.
Moreover, there is a strong case for the positive outlook for emerging economies. “Emerging market equities remain an attractive asset class for global investors, not least because of the factors we are familiar with, such as favourable demographics with young populations and tremendous spending power,” Nguyen says.
Here there is a strong narrative with middle class consumption as a key driver of global demand, led by more people entering the middle classes in emerging countries. Putting this into simple numbers, 65% of middle class consumption will be in emerging markets by 2030, up from 33% today – almost doubling in less than a decade.
Asia accounts for half of the world’s consumer class, which are people spending more than $11 a day. The IMF forecasts that GDP across the developing world will be 6.3%, beating expectations for its advanced market peers (5.6%) and the global economy (6%).
“The fundamental story offers room for optimism as emerging markets are expected to grow faster than developed markets,” Nguyen says.
Kunal Ghosh, chief investment officer of systematic strategies at AllianzGI, is also bullish on emerging markets. “Institutional investors should allocate their emerging market equity exposure to the upper levels allowed by guidelines,” he says. “From the perspective of the MSCI ACWI, emerging market countries only represent 13% of this global equity index. This exposure level, in our view, under-appreciates the importance of emerging markets as a key engine for the global economy.”
Emerging markets are driving more than half (60%) of global GDP – on a purchasing power basis. Emerging markets represent 85% of the world’s citizens, indicating significant market size and buying power.
“For investors who are underweight emerging market equities, it is important to highlight that these countries are behind more than two-thirds of global growth,” Ghosh adds. “There exists upside risk to discounting this key global growth driver, which also carries a robust set of opportunities for equity security selection and alpha generation.”
North American exposure
The standard attraction of emerging markets, especially for pension funds, is typically a source of additional return due to faster growth rates and a valuable diversifier from conventional developed markets. This is down to the different industries, monetary and fiscal policies, and, of course, political systems.
North American pension funds have sought to benefit from emerging market growth. Alain Carrier, senior managing director of CPP Investments, the investment arm of the Canada Pension Plan, aims to have as much as a third of the portfolio in emerging markets by 2025. It currently stands at around 22% with the lion share in China.
In the past year, emerging and developed markets, have “contributed significant investment returns” for the $497bn (£286bn) Canada Pension Plan.
But Carrier is also a “big believer” in India. The country makes up a small, but growing portion of the portfolio. Carrier expects India to be an important driver of long-term value alongside some of its neighbours in Asia and even Latin America.
According to Carrier, emerging markets are going to be an important driver of the value of diversification, where the talk is about decoupling. “Decoupling can be a risk, but it could also be an opportunity in terms of reducing the volatility of the portfolio,” he adds.
Another example of a successful exploitation of emerging market equities, is the $1.1bn (£799m) Merced County (California) Employees’ Retirement Association pension fund, which banked an impressive 53.9% net return from emerging markets equities in the year to the end of June. The $1.8bn (£1.3bn) Louisiana Firefighters’ Retirement System also collected emerging markets equity returns of 42.2% – beating its 40.9% benchmark.
Closer to home, one of the UK’s largest local authority pension pools, Border to Coast, has restructured its Emerging Market Equity fund to focus on China, and which is now, following fresh commitments from partner funds and investment growth, worth more than £1bn.
The fund was restructured to reflect the increasing importance of the world’s second largest economy. As part of the restructuring, the fund’s benchmark has been revisited and is now based on the FTSE Emerging index with China specialist managers benchmarked against the FTSE China index. Daniel Booth, Border to Coast’s chief investment officer, says, “We see China as a key hub for innovation and growth and believe that our approach will maximise our investors’ risk- adjusted returns.”
There have been big differences in how emerging market countries handled Covid. This has implications for how quickly certain countries have emerged from the pandemic, resulting in stark divergences.
On the one hand, China, South Korea and Taiwan took early and decisive measures to control the spread of Covid. As a result, these economies are recovering faster than many of those which reacted slower. As countries take steps to get vaccinated, this will further accelerate the pace of improvement.
There have, therefore, been some interesting drivers arising from Covid. When the pandemic hit and the whole world was in various stages of lockdown, there was a big shift to online shopping, which benefited ecommerce and payments companies across emerging markets, especially in China and Latin America. The gaming industry is another winner from the Covid-inspired lockdowns.
Although at the same time, China’s regulatory crackdowns may have dented the investment case for some companies within the technology, education and property sectors in mainland China and Hong Kong, but this could be a temporary blip.
Covid has no doubt boosted the emerging market tech story. “What has been exciting is the leapfrogging of technology, where ecommerce, fintech, mobile payments, online education and cloud computing companies have jumped ahead,” Nguyen says.
In this scenario, there has been a shift towards ecommerce and mobile payments, which has been facilitated by the growing penetration of smartphones – a key driver of consumption. Companies are also leveraging artificial intelligence given the massive amounts of data across so called ‘verticals’, including technology, healthcare and consumer, that they have access to.
“The huge demand for electronics with work from home and remote learning has led to strong demand for semiconductors, and thus a global chip shortage,” Nguyen says. “Semi-conductor companies in Taiwan and South Korea are benefitting from this.”
Nevertheless, there are clouds on the horizon. “The growing concerns about rising inflation and the increasing likelihood of a Fed taper have fuelled worries about the impact on emerging markets, especially recalling the severe reaction to the taper tantrum of 2013,” Nguyen says.
Putting this into perspective, in 2013, many emerging market economies had large current account deficits that made them vulnerable to external financing, which was harder to avail of with rising treasury yields.
“The situation today is quite different,” Nguyen says, “with most emerging markets enjoying current account surpluses at the end of 2020. Therefore, the improved current account balances should limit emerging markets’ vulnerability to higher rates given less dependence on external financing.”
Context is, therefore, important. If higher yields in emerging markets imply that the recovery will be faster than expected, this is generally good for emerging markets because it suggests a resurgence of growth. It does mean that the cost of capital will go up across the board, but if accompanied with a stronger economy, then companies will generally be able to absorb this. However, if we have slower growth accompanied by higher inflation, that is more problematic.
“A spike in yields has implications for growth stocks because future cashflows have to be discounted at a higher rate, which lowers the present value. Meanwhile, there have been concerns about elevated valuations,” Nguyen says.
When you look at relative valuations, emerging markets present a compelling picture versus developed markets: the MSCI EM index trades at 12.3x 2022 price-to-earnings ratio versus the MSCI World, which only includes developed markets, at 18.8x and with the S&P500 at 20.3x.
High growth sectors like technology and communication services together comprise less than a third of the MSCI EM index, whereas they account for an almost 40% share of the S&P500.
In addition, emerging market Covid vaccination rates are ramping up and the region is heading towards a full economic reopening. “Eventually, we will reach a point where the global economy can put Covid restrictions in the rear-view mirror,” Ghosh says. “It is at that point we will see emerging markets really shine.”
Indeed, things have shifted significantly during the past decade, with today’s emerging markets looking different compared to the start of 2010, as smokestack sectors – energy, utilities, industrials and materials – fell from 56% of the MSCI EM index to a mere 20% today.
An evolution of this trend, and a further case for emerging markets is that technology-oriented industries are now 37% of the MSCI EM index, rivalling the 39% of the MSCI US. “With a burgeoning middle class and continued technology innovation, emerging market nations evolved to be a key participant in the digital era, driving robust growth over the course of the next decade,” Ghosh says.
So, which are the most attractive regional segments of emerging market equities? “Right now, we believe Taiwan and South Korea are attractive regions, especially with respect to their technology hardware and semiconductor capabilities,” Ghosh says.
“The world’s most advanced semiconductor chips are being produced in these two countries and the ongoing chip shortages further benefit companies across this ecosystem. We are also largely overweight to Russia, which offers attractive valuations with solid free cashflow generation.
“Russia also represents the primary avenue for our energy exposure, which should benefit from a forthcoming re-opened global economy,” Ghosh adds.
But Nguyen counters. “We don’t think about investing in emerging markets based on a regional approach. Rather, we focus on identifying quality, growth companies and sustainable business models with idiosyncratic drivers that can add value through a variety of economic environments.
“We believe we can add value through our active, bottom-up approach and that the current volatility offers more opportunities for a differentiated approach,” Nguyen adds.
Ghosh notes that compared to international developed and US equities, emerging markets have a greater level of “heterogeneity” and idiosyncratic trends. While there are reasons to be bullish on Taiwan, South Korea and Russia, there are other emerging market countries where risk and reward might appear unfavourable.
This includes China’s internet companies, which are experiencing intervention from the central government and could undergo outsized volatility. “Overall, active management should be the primary instrument in the institutional investor’s toolkit to take advantage of the opportunities in emerging markets equities,” Ghosh says.
There can be no doubt that real skill, and sometimes a strong stomach, are needed when allocating to emerging markets, but for long-term investors, developing economy equities offer real attractive opportunities.