Emerging markets have been top of investors’ wish lists for the reflation trade: $17bn flowed into the asset class in the first three weeks of the year as global investors looked for ways to take advantage of the global recovery. Does this mark the end of a long period when the asset class has been overlooked by investors?
Certainly, many of the most compelling trends in emerging markets haven’t gone away: the consumer is going from strength to strength; demographics are still in their favour; infrastructure building and urbanisation are contributing to economic growth and technical innovation continues apace. At the same time, improving governance is making them an easier place to invest.
Equally, most emerging markets haven’t performed badly during their period out of the limelight. Most have delivered reasonably well for investors over the last five years, just not as well as the S&P 500. However, it means that as people revisit the asset class, they may be pleasantly surprised. China, Korea and Taiwan, in particular, have been strong performers over the last year.
The US dollar is likely to be important in the relative ‘stickiness’ of assets in emerging markets. With a vast stimulus package on the table from the new Biden administration, the US dollar has weakened. This is likely to broaden the appeal of emerging market currencies and emerging market assets more generally in 2021.
Once investors have warmed up to the asset class, a second question will be where to direct their capital. On the one hand, there is China, with its large technology companies and compelling economic growth; on the other are the commodity producers – Brazil, Russia, South Africa – which have performed poorly during the pandemic but may now be poised for a revival as the global economy picks up.
Many of those coming back to emerging markets have sought to focus exclusively on China. This is perhaps understandable: it has seen a strong pandemic response, its economy has held up well, its stock market was second only to the technology sector for 2020. It now constitutes 40% of the MSCI Emerging Markets Index and six of that index’s top ten holdings are from China.
However, to our mind, a narrow focus on China is a mistake. It is an area where investors should be spreading risk. It is still communist, some of its debt metrics still look frothy and it could be the first global economy to start monetary tightening, not least to minimise the risk of bubbles in, for example, the real estate and equity markets. We have also seen some excess building up in the ‘A’ Shares market as private investors have taken a greater interest.
A focus on China also risks missing out on some of the other good growth stories in emerging markets. There are large swathes of emerging markets that get much less attention – Africa, Eastern Europe, Latin America and the Middle East. These have largely been overlooked in recent times, particularly during the pandemic and yet it’s in many of these markets that valuations look most compelling and opportunities most abundant.
We would caution that while there can be little doubt that China will continue its unstoppable rise in global prominence and China’s economic growth has smashed even the most optimistic estimates, any sound emerging market investors needs to consider the broader universe of close to 40 countries.
It isn’t so long since many people were saying there was little future for the extractive industries. The planet was going green – there was no room for mining in this brave new world. This inevitably had an impact on those emerging markets where commodities form a large part of their economy.
This has come full cycle. It is increasingly clear that the energy transition cannot take place without the extractive industries. They can’t make electric cars without lithium, while renewable energy infrastructure is uniquely dependent on copper. The green revolution needs metals to make it happen. Increasingly, we see countries such as Brazil, South Africa and Russia as beneficiaries of a renewed focus on sustainability rather than victims of it.
The US technology giants have had great success in developed markets across the world, particularly during the pandemic. Investors have come to rely on Amazon deliveries for their shopping, or Microsoft Teams for remote working. However, they have not achieved the same penetration in emerging markets, where barriers to entry are far higher.
It is often local champions that stand in their way. In Russia, for example, there are sanctions in place from the US, so there can be no Amazon. This has allowed domestic companies to flourish. Through an investment in a Russian private equity fund we benefitted significantly from two Initial Public Offerings (IPOs) in late 2020.The first to go public was a Kazakh company that listed in London in October, Kaspi. This is Kazakhstan’s answer to PayPal. Ozon listed in New York in November. This is Russia’s leading online marketplace. Both names have seen explosive growth and have vast addressable markets, but are not talked about in the same way as their Western equivalents.
This is a trend across emerging markets. It is possible to find growth names, similar to those that attract such elevated valuations in the US market, but at far more realistic prices. We believe these anomalies will adjust as capital comes back to emerging markets. The IPO markets are already bouncing back to life, bringing new and exciting opportunities for investors.
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