Making a case for emerging markets (EM) investing has never been straightforward. There has always been a struggle between the lure of superior returns and the suspicion that, sooner or later, disaster or instability might wipe these out.
Indeed, a series of shocks – including the 1980s’ Latin American debt crisis, the 1990s’ Asian financial crisis and concerns about higher US interest rates in 2013 – have repeatedly driven investors to withdraw their capital, causing a pattern of boom and bust.
Doubts still linger over how many EM countries can actually achieve developed status, or the justification for investing in emerging market equities from the standpoint of returns.
But none of this necessarily means investing in emerging markets isn’t worth it. On the contrary, there are many signals that the best may be yet to come.
So, looking ahead, what is the appeal of investing in emerging market equities and how can stock pickers succeed in this specialist discipline?
Growth on the horizon
When the case for an allocation to emerging market equities is made these days, it usually centres around relative valuation. This is reasonable enough: the asset class has gone nowhere for a decade, while developed markets – led by the US – have gone from strength to strength.
These valuation-based arguments are increasingly being supplemented by a new-found appreciation of emerging markets’ macroeconomic resilience.
Sure enough, we have just gone through the most aggressive Fed tightening cycle in a generation, and most of the major emerging economies have sailed through unscathed. But the case for growth in emerging markets isn’t being discussed nearly enough.
We are constantly told that the golden age of globalisation is at an end, and that emerging markets, as the biggest prior beneficiaries of this trend, will be the most challenged by its reversal.
Yet what we are seeing is not de-globalisation, but de-sinification as the West seeks to grind China out of its system. There will be winners elsewhere in emerging markets as supply chains adjust, new export champions emerge in countries such as Vietnam and Indonesia, and capital flows to these markets.
A shifting centre of gravity
Equities in Mexico, South Korea, Vietnam and India are finally attracting more attention after a decade of neglect.
That’s because, when it comes to the key challenges we are likely to face in coming decades, many of the answers are in the developing world.
If you think about the transition to renewable energy, we're going to require an awful lot of critical minerals, copper and nickel.
If you think about developed markets reviving their manufacturing sectors, we’re going to need an awful lot of steel and cement. And if you think about artificial intelligence (AI), we’re going to need lots of semiconductors.
When I think about all those things, the idea that the world's centre of economic gravity will continue to tilt towards emerging markets seems very plausible.
Macro matters
What, then, is needed to take advantage of this change in headwinds? The extreme nature of cycles in emerging markets means there can be long periods of time when top-down factors are overwhelming.
Some investors will tell you that macroeconomics doesn’t matter, it’s all about finding great companies and focusing on fundamentals. But I would respectfully tell you that it does matter in emerging markets.
If you pick the right companies at the wrong moment, currency moves and stricter lending criteria can send the value of emerging market stocks and bonds into a tailspin. But the results can be stellar when both factors work in your favour. And there are signs to suggest such a period is on the horizon.
We’re still below the 2007 peak in the MSCI Emerging Markets Index at a time when other global stock markets have done well, and more capital has left emerging markets than has flowed in for the best part of a decade.
The result is that asset prices appear undervalued compared to other markets. And from emerging markets, more and more world-class companies are appearing.
World-class companies
Take Taiwan Semiconductor Manufacturing Corporation, better known as TSMC. It has close to a 60% market share in manufacturing chips for third parties, and counts Apple, Nvidia and Qualcomm among its biggest clients.
In the 1990s, it was about twice the size of its nearest competitor, United Microelectronic Corporation. Now, it’s six times the size. It got there by doubling down every time there was a down cycle, while its competitors retrenched.
Nobody knows what the new digital age will look like, or which AI applications will be most successful, but we have a good idea that TSMC will be making the semiconductors powering them. I think the market still misses how much value it could create.
India, too, has many promising startups, while its larger brands benefit from the public’s growing disposable income. Much of this potential is already reflected in valuations. However, Jio Financial Services is one example of a company whose prospects are particularly bright.
There are hundreds of fintech companies in India. What makes this one special is that it’s backed by Reliance Industries and has access to all its data. We’re talking about 400 million telecoms customers and 200 million retail customers: that’s a powerful combination.
Patience can be profitable
We can go quite far in imagining where the tilt towards emerging markets might take us.
If the early 2000s were about the integration of China and the West, the 2020s are poised to see something much broader: 4 billion people in 100-plus EM countries that are doubling down on trade with both sides of the geopolitical divide.
Evidence of this is already becoming economic reality, as emerging market countries trade with each other more than ever. This is increasingly happening in currencies other than the dollar, further liberating emerging markets from their historical dependence on US policy.
The profits from this new wave of globalisation are likely to be reinvested into emerging markets themselves. It could be a far more powerful and self-sustaining trend than anything that has unfolded before.
Anticipating these longer-term dynamics is more straightforward than trying to time the turning points in cycles: collapse is followed (at some point) by supply withdrawal and stimulus, which is followed even later by recovery. So, if you have the luxury of a long-term investment horizon, patience can be profitable.
Will Sutcliffe is head of Baillie Gifford’s emerging markets equities team. The views expressed above should not be taken as investment advice.