The term ‘emerging markets’ was first used by an economist in 1981. It certainly qualifies as an understatement to say that, over the past 42 years, much has changed globally in terms of an economic, political and social perspective.
The Morgan Stanley Emerging Market Index contains around 1,420 constituents, however just five countries – China (29.5%), Taiwan (15.6%), India (14.6%), South Korea (12.3%) and Brazil (5.5%) –account for more than 75% of the Index.
Of these China now accounts for about 17.1% of Global GDP with India coming in at around 3.2% currently, (slightly ahead of the UK at 2.8%), hardly ‘emerging market’ metrics.
It is clear that economically, if not politically, the top five constituents of the MSCI Emerging Markets Index can no longer be described as ‘emerging’, as they are all major contributors to global GDP and play an important role in ensuring that global growth potential is achieved within an optimal inflationary/deflationary framework.
One of the benefits of investing in emerging markets is the diversification it offers given the widely differing economic growth rates across the countries involved as well as clearly differing social and political risks.
That said, and in contrast to most major developed economies, many of the countries within the emerging markets enjoy very favourable economic tailwinds including positive demographics, growing middle class with increasing disposable income, low levels of personal debt and also pension systems that are embryonic but growing strongly.
So, what are the risks?
There are obviously many risks associated with investments in emerging markets but the three major ones are political risk, FX risk and liquidity risk.
Whilst these are some of the major risks in emerging markets they can, counterintuitively, sometimes help create attractive investment opportunities because investors, almost inevitably, often over-react to these perceived risks.
Current investment opportunities
Emerging markets have performed well this year based on three broad trends: a continuing move away from the US dollar as a trading currency; a move to re-shore supply lines away from a dependence on China; and a structural bull market in commodities due to years of chronic underinvestment.
Drilling slightly deeper into opportunities we favour
India has been a major beneficiary of asset re-allocation away from China. Its economy is growing at just over 6% per annum and inflation is beginning to head lower, allowing the RBI room to adopt more dovish monetary policies.
Whilst equity valuations are elevated, growth potential at least justifies higher multiples. In a world where many investors believe the West is facing a slowdown and, at worst, a recession, any market which can provide evidence of realistic growth prospects over the longer term, is going to command interest.
However, for investors worried about current Indian equity valuations then Indian government bonds might offer attractive risk reward characteristics particularly with the Indian Rupee trading close to all-time lows vs GBP.
Next, Latin America markets have done very well this year with Mexico in particular faring well from the “re-shoring” theme. That said we think structural underinvestment in commodities over the past few years means that Latin America should be well positioned to benefit from higher commodity prices as the Fed approaches the end of its tightening cycle and the dollar at least pauses for breath, if not continues to head lower.
Lastly, Asia Pacific is home to a growing demographic of rising middle class with increasing disposable income. Countries such as Indonesia, Vietnam and Thailand stand out as good long-term beneficiaries of demographic trends. Interestingly we believe this theme allows investors to participate both via equity exposure and fixed income exposure.
Emerging markets to avoid currently
We noted that China is the world’s second largest economy and accounts for close to 30% of the MSCI EM Index. For a long time, exposure to China was almost a given for most global investors. However, over the past couple of years that has changed and for two main reasons.
Firstly, a crackdown by the Chinese government, which began in November 2020, and which targeted many of the large-cap tech companies, made investors reassess and question the safety of investments in China.
Secondly, the global lockdown caused by Covid laid bare to many, including the US, just how dependant their economies were (and still are) on China causing them to begin moving production centres out of China.
On top of these two headwinds China has had a very laclustre re-opening from Covid and investors are rightly concerned about the level of NPL’s lying within local government financing vehicles. This has caused the government to put pressure on Chinese banks to adopt extremely ‘creative’ approaches to rolling non-performing loans.
Taken in conjunction the foregoing surely indicates that China will continue to struggle to generate any real growth this year and will, in fact, revert to being an exporter of deflation to the global economy, which may not be a bad thing for the rest of us, but will add social pressure domestically.
Ways to gain exposure to emerging markets themes
For investors looking to access emerging markets it is probably best to do so via either ETF’s or funds given that issues related to time difference, local currency issues, foreign ownership limits, custody issues etc. make direct investment very difficult.
Mike Hollings is a partner at Shard Capital. The views expressed above should not be taken as investment advice.