Emerging potential

Recent columns have highlighted favoured markets and sectors as our portfolios continue their pivot toward equities at the expense of other, more defensive assets including cash. The UK market and private equity sector has been the focus of this transition given they perhaps best illustrate the extent to which market sentiment is poor relative to outlook and investment trust discounts have widened. However, exposure has also been increased to other equities including emerging markets given the margin by which the MSCI Emerging Markets (EM) index has underperformed developed markets. Various tailwinds are now aligning which could make for a meaningful re-rating.

Economic reality

Emerging economies have hit a perfect storm in recent years. Rising energy prices, interest rates and inflation have adversely impacted most markets. However, with Chinese equities accounting for 30% of the MSCI EM index, the country’s lingering hangover from Covid has perhaps cast the biggest shadow for many emerging markets given it is a major source of demand. Concerns remain about the country’s economic woes. In part because of geo-political tensions, including its strained relations with the US and Taiwan, investor attention has focused on the extent to which Western companies move production elsewhere.

More generally, there is also a concern that much touted talk of de-globalisation will severely impact emerging economies given the extent to which growth has depended on exports to developed economies in the past. For example, sentiment has been adversely affected by the US-China tensions over semiconductors, which has involved trade restrictions, export controls on certain Chinese technology companies, and the huge US government support for its own industry via its Inflation Reduction Act. Other tensions and geo-political events have not calmed nerves.

Over the last decade, emerging markets have also suffered from other factors including a reversal of speculative fund flows influenced at times by an inverse relationship with the US$ and interest rates. A stronger dollar makes it costlier to service $-denominated debts and the commodities, including oil, many emerging economies import. Some investment strategists also believe, in contrast to US companies, the profit margins of many emerging market companies have fallen over this period – perhaps in part influenced by the costs of defending market share and maintaining R&D – though this may now be reversing.

However, at least some of these concerns have been overstated. As China reemerges and its indices rebound, investors should reflect on the economic reality that a complete relocation by Western companies is unlikely given many emerging economies are integral to global supply chains. Recent news that Apple, which has shifted some production to Vietnam over the past year, is now looking to step up its production of the next iPhone at its Chinese factory in Zhengzhou, owned by Taiwan’s Foxconn, is perhaps an example of commercial reality tempering political objectives and postering.

Investors should take note. Talk of deglobalisation and China’s woes may have affected sentiment in recent years, but the fundamental reasons for investing in emerging markets have not changed. One is sheer scale. Emerging markets are home to six billion people, whose GDP per capita has grown from c.$4,300 in 2000 to nearly $16,000 today – this compares to an average of $55,540 in developed economies. The number of people living in emerging markets – 85% of the world’s population – mean they account for nearly 60% of the world’s GDP today, and this figure continues to rise.

While forecasts should always be taken with a dose of salt, it remains likely that economic growth will exceed that of developed economies. And much of this growth is from growing cities. According to the consultancy firm McKinsey, an estimated 440 emerging market cities are expected to have contributed around half of global GDP growth between 2010 and 2025. Rising prosperity is resulting in increasingly wealthy populations, rapid urbanisation, and huge investments in physical infrastructure. Estimates suggest $25 trillion of capital will have been injected over this period from the creation of a four billion consumer market.

Indeed, many countries now boast greater economic resilience and stronger growth. Previously considered purely as a source of commodities and cheap labour, many economies possess deeper pools of demand with domestic consumption having nearly tripled over the last decade or so. This looks set to continue. Meanwhile, bigger currency reserves and a lesser dependency on the US$ for borrowing, as many governments look to diversify their currency exposure, will reduce the effect of sometimes overly fickle foreign capital flows. Younger and well-skilled populations are further reasons to be positive.

It is perhaps no surprise that emerging countries have proved resilient during the economic slowdown. At the start of the first EM indices, there were around 25 emerging nations in financial default – today that figure is around five. Furthermore, a fear of inflation has prompted a more proactive approach to interest rates with many central banks raising rates earlier than their western counterparts. Therefore, while inflation will remain ‘stickier’ and more volatile than consensus forecasts suggest, these central banks will have greater latitude in cutting rates sooner as inflation levels fall somewhat.

The investment case

It remains a truism that a key determinant of total returns over time is the extent to which the price paid represented good value. Other factors contribute including the performance of the underlying universe from which the investment has been chosen, whether the fund managers achieve outperformance relative to relevant indices, and the length of time invested to best compound returns and ride-out short term volatility. But the price paid remains of key importance. Currently, emerging markets appear very good value indeed relative to outlook.

Figures suggest that since 2012 emerging markets have underperformed developed markets by as much as 60% – and in the process have lost much of their outperformance since the first emerging market indices began in the second half of the 1980s. The US market now trades on cyclically-adjusted price/earnings multiple of around 24, while emerging markets trade on 11 – a near 25-year low. In fact, by many measures, the EM index is now at its cheapest since being introduced. Yet the outlook for growth when compared with developed economies remains encouraging.

And while the macro-economic outlook looks promising, fund managers are spoilt for choice at a company level. Company returns over the last decade have broadly matched those of developed markets but share prices have been savaged – having de-rated from a comparable price/book value to now barely half of that. Indeed, while there will always be exceptions, emerging market companies in general are less dependent on debt, have improved corporate governance, and boast competent managements which are becoming increasingly aware of the importance of good shareholder relations. Not a bad combination.

Of course, markets can stay cheap for indefinite periods. However, several tailwinds of varying strengths are now aligning which, cumulatively, may have the desired effect. A short-term catalyst could be emerging countries being among the first to cut interest rates as inflation subsides somewhat. At some point, there will be greater recognition of the corporate governance improvements. The search for sustainable and growing income is ongoing globally, with Asian companies especially being of value. In addition, emerging markets can often be in the vanguard when market sentiment more generally improves.

Not all emerging markets will rise together. The implosion of Russian markets, stagflation in South Africa, and concern over Human Rights in others, are reminders. Comparisons between the two largest emerging markets, India and China, is another. Both have populations of nearly 1.5 billion people but, at roughly $18 trillion, China’s nominal GDP is nearly six times that of India’s. And while both countries had broadly the same GDP per capita in 1990, China’s average of c.$21,400 is now more than 2.5 times higher than India’s. It may be time for India to play catch-up.

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