Investing in a product you hope you’ll never use
Insurance is a funny thing. It’s the only product that both buyer and seller hope is never used. But...
Negative headlines have dominated the sphere of emerging markets in 2019, with the region facing significant macroeconomic challenges such as weakening economic growth, ongoing trade spats and considerable geopolitical uncertainty.
The result has been relatively disappointing performance for emerging market equities: the MSCI Emerging Markets Index has significantly underperformed the developed world index year-to-date (7.95% vs 16.7% for the MSCI World*). A recent note from Lazard Asset Management attributes underperformance in 2019 to investors believing globalisation – a major driver of emerging market development for many decades – is no longer sustainable. The asset manager adds: “Global consensus on the benefits of trade have collapsed, and populist parties have become political forces around the world”.
The International Monetary Fund says emerging market and developing economies are expecting to grow 3.9% in 2019, a fall from 4.5% the previous year, before bouncing back to 4.6% in 2020**. It says the improvements next year will be partially due to “shallower recessions in stressed emerging markets, such as Turkey, Argentina, and Iran” with the rest coming courtesy of improvements where growth slowed significantly in 2019, such as Brazil, Mexico, India, Russia, and Saudi Arabia.
While this may seem negative in the short term, one thing investors should remember is that the long-term story for emerging markets remains a strong one, as urbanisation, improving demographics and productivity continue to favour the market. And while growth may be slower this year, emerging markets now account for almost three quarters (74%) of GDP growth globally, while 40% of global economic activity comes from companies based in the region***.
It’s also an evolving story – with many changes occurring in the region, which are opening the doors to new investment opportunities. Here is a short guide to some of the key issues impacting emerging markets and how investors could benefit.
There is no doubt that a slowdown is occurring in China, the world’s second largest economy, which sources almost 20% of global growth. Growth in 2018 registered at 6.6%**, the lowest rate recorded in 28 years. This year the IMF expects it to fall to 6.1%** while Chinese Premier Li Keqiang has said that exceeding 6% GDP growth in this current macroeconomic environment is not realistic.
However, one option which has opened up to investors recently is the decision of the MSCI to increase the weighting and breadth of China A-shares exposure in its emerging markets index, as well as its China index and other regional indices. This presents a significant opportunity given current exposure to Chinese equities in the MSCI Emerging Markets Index is heavily weighted to mega-cap internet companies and large Chinese banks.
Trade wars have been the biggest stick used to hit the world economy in 2019. Global growth has declined by 1.2% since President Donald Trump kicked off the argument by ordering tariffs on steel and aluminium in the first quarter of 2018^. Many expect it to be a multi-year dispute, despite sentiment changing on a daily basis about the potential for a deal.
However, there will be winners from the two biggest superpowers locking horns. As global manufacturers diversify their supply chains to the likes of Vietnam and Taiwan – who are not subject to tariffs. While US imports to China were down 5% year-on-year in the 12 months to July 2019, they rose 23% and 15% in Vietnam and Taiwan respectively^.
Of course, it’s not all about China, as other countries are also making changes to make themselves more attractive for investors. India is expected to grow by 7% in 2020** and has made numerous strides under prime minister Narendra Modi since 2014 – such as the Goods and Services Tax, inflation targeting and the implementation of its bankruptcy code. It’s also another country looking to take advantage of trade wars by offering new manufacturing companies a tax cut from 25% to 15%.
Others have also made reforms. Indonesia’s re-elected President Joko Widodo is looking to lower corporation taxes and loosen labour laws, while the government has announced plans to increase its infrastructure spend. Brazil has also made major strides on pension reform, as well as proposals to privatise state-controlled companies.
Exchange rate movements against the US dollar are an important factor shaping the outlook in emerging market economies, as a large share of their credit, trade and debt is priced in dollars. This means a strong US dollar is bad news for the region.
However, the move to a more cautious stance by the US Federal Reserve (central bank) earlier this year should help the region by taking pressure off the US dollar and giving emerging economies some breathing room. This will particularly help those countries with both current and fiscal deficits or significant debt in US dollars.
Emerging markets heavily outperformed their developed peers in the late 1990s and early 2000s, courtesy of China’s double-digit growth and huge investment into resources – a move which benefited the wider region. This commodity-fuelled performance has since waned, particularly as China has transitioned to a more consumer-led economy, with the relationship between commodity prices and emerging market performance dissipating.
Services in China accounted for over half (51.7%) of the economy in September 2017, compared to 33.5% two decades earlier^^. It’s a factor supported more widely in the MCSI Emerging Market Index weightings, where the consumer and technology sectors have risen in importance in the past decade. Contrast that to energy and materials, which now account for 14.8% of the index (vs. 29% a decade earlier)^^.
Emerging economies can no longer be categorised in one simple bloc, particularly as they evolve to become less export driven. 82% of emerging markets funding is now domestic^^^, making capital flight less likely. The likes of Turkey and Argentina (both of which are yet to establish this domestic funding) are exceptions to the rule, as there is less confidence in their respective currencies.
A recent report from Wellington Management highlighted four key structural changes within emerging markets – all of which they believe are going under the radar and represent a major opportunity for investors. It cited the ongoing progression in the region to move away from “growth at all costs” to an “economic development” focus.
It says these changes are focusing on greater inclusiveness, enhanced productivity, improved living standards and better sustainability. These changes look set to have a major impact on numerous sectors of the economy such as healthcare, education, recycling and energy efficiency, many of which are under-represented in public markets. Healthcare is a good example, as pharmaceutical demand continues to rise with an aging population and a growing middle class. Wellington expects healthcare to play a major role in the future, yet it only accounts for less than 2.6% of the MSCI Emerging Markets Index at present^^^^.
New investors who may be dipping their toe into emerging markets for the first time may want to consider the likes of the Magna Emerging Markets Dividend fund, managed by Ian Simmons. The fund is focused on finding the best companies, rather than predicting market or economic trends. The team search for companies that are able to pay high dividends in the short term but are also able to grow those dividends over the long term.
Another worth considering is the Guinness Asian Equity Income fund, which invests in companies across the whole Asia Pacific region, including Australia. The portfolio is concentrated in just 36 equally weighted stocks, and has a one-in, one-out policy, looking for a combination of capital and dividend growth.
More experienced investors may want to invest in vehicles with a specialist focus within the region. A good example of this would be the Aberdeen Standard Investments Latin American Equity fund, managed by Devan Kaloo. The investment process is based entirely on fundamental research, with four or five company visits usually taking place before an investment is made.
Another to consider is the IIFL India Equity Opportunities fund. Jonathan regularly travels to India and has a wealth of experience investing in the market. He adopts a bottom-up process when looking for stocks, eventually building a portfolio of 20-30 holdings.
*Source: FE Analytics, total returns in sterling, 31 December 2018 to 23 October 2019
**Source: IMF World Economic Outlook, October 2019
***Source: Ashmore, The emerging view, October 2019
^Source: Lazard, Outlook on emerging markets, October 2019
^^Source: T.Rowe Price report October 2019 – Emerging Markets: Reward or Risk
^^^Source: Ashmore – The Emerging View – The power of Top Down: 7 Implications for EM equity investor
^^^^Wellington Management – Structural change in markets: 4 key forces to understand