Investor sentiment towards emerging markets has taken a significant hit so far this year thanks in part to severe currency depreciation in certain developing nation currencies. These concerns have driven the discount between emerging and developed market equities to a near-five-year high, despite underlying growth and profits remaining robust or unchanged across many emerging market firms.
Country weightings of the MSCI Emerging Markets index
While it can be convenient to group emerging markets together under one banner, this clear disconnect shows how the widespread fear of ‘contagion risk’ created by this practice can exaggerate the links between countries. At a time when some emerging markets are experiencing difficult but specific problems and others are continuing to grow, it is worth remembering that the bloc consists of a wide variety of economies driven by very different factors.
Different risks
While it is true that several emerging market currencies have fallen this year, the situations in Argentina and Turkey appear to the most dangerous. Argentina’s government is in a fiscal crisis amid high inflation and the prospect of an IMF (International Monetary Fund) bailout, while US sanctions in Turkey have exacerbated existing concerns around overly-politicised monetary policy. The risk in these two countries is made worse by the presence of large, foreign-funded current account deficits, which become harder to pay back when sentiment turns weak and currencies depreciate – as has happened.
Unlike Argentina and Turkey, many other emerging market countries are in a much healthier state because they are less exposed to foreign debt and their current account deficits do not sit at dangerously high levels. Indeed, one look at the IMF’s current world economic outlook shows that, aside from Turkey and Argentina, the only other countries with a negative outlook are Saudi Arabia, South Africa, and Russia. Meanwhile, the organisation’s stance on heavyweight nations such as Brazil, India, and – most notably – China, is either ‘broadly consistent’ or ‘stronger’.
Counry weightings of the MSCI Emerging Markets index
Source: MSCI
With China alone accounting for a higher percentage of the emerging markets benchmark than Latin America and Europe, Middle East & Africa (EMEA) combined, it is not hard to see why Turkey and Argentina’s problems are yet to evolve into contagion.
Sector make-up
Another point for emerging markets investors to consider is the widely varying economic drivers and market sector concentrations between individual regions and countries. For example, while Asia has significant exposure to technology, Latin America and EMEA have substantial concentrations in materials, energy, and consumer staples.
Thanks to their unique makeup, these different areas are liable to react to macroeconomic changes in entirely different ways. For example, a rising oil price benefits oil producers such as Brazil, Qatar, and Russia, but hurts oil consumers such as India, Korea and Thailand.
By grouping these highly disparate emerging markets, factors negatively impacting one country or region can have a disproportionately high impact on another. For these reasons, it is worth taking a closer look at the country and sector weightings in the benchmark when investing.
Performance of index in 2018
Source: FE Analytics
Investment opportunity
We assess macro risks in terms of their impact on underlying businesses and the valuation of their shares. In this sense, if we can satisfy ourselves that a robust company will continue to thrive regardless of macro conditions, then the depressed valuations in emerging markets created by grouping together nations presents an opportunity.
There are three parts to the total shareholder return: profits, earnings multiples, and dividends. We seek out sustainable and growing profitability that, in turn, underpins a sustainable and growing dividend. The earnings multiple is the volatile element, and when it is low, it can present the perfect time to enter a strong business.
Edmund Harriss is portfolio manager of the Guinness Asian Equity Income and Guinness Emerging Market Equity Income funds. The views expressed above are his own and should not be taken as investment advice.