Rethinking emerging markets

A decade of disappointing absolute levels of return for emerging markets has investors re-thinking their exposures. But emerging markets are still more than 50 per cent of global GDP, and with growth driven by an entrepreneurial culture these companies are a key part of the “new global economy”. A group of investors convened in London to explore opportunities, the right risk/ return trade off and how to best gain exposure.

It may seem counter-intuitive to kick off a roundtable discussion on emerging markets talking about the United States but what happens in the US has an important impact on the rest of the world, given the size and interconnectedness of the US economy and investors’ relative diversification away from it, or overweight to it.

A functional US and China relationship is particularly important for global growth.

For investors, the Federal Reserve’s interest rate policy and stimulus pose a key challenge for allocations to emerging markets, as dovish policy has underpinned US growth for almost a decade, and helped the US stock market and, in turn, global equities outperform emerging markets.

But the outlook for emerging markets is on the up and up. On top of traditional arguments, including diversification, higher populations, and the rise of the global consumer and middle class, the wave of capital that has flowed out of emerging markets and into developed markets over the past five-to-six years, has driven developed market valuations higher and higher, and increased the attractiveness of emerging market opportunities.

“It’s clearly an interesting time for investors as we’re likely entering a period of heightened volatility around issues like trade and international relations,” said Derek Walker, managing director, head of portfolio design and construction, total fund management at Canada’s CPP Investments.

“We try and separate short-term dynamics from our thinking on the long-term in our strategic asset allocation. On the long-term side, our focus is on determining if there are structural shifts?”

“When it comes to the dominance of the US in the global financial system and its role in the global economy, we’re not seeing dramatic changes on that front, at least over the near term.”

Despite a “cautious” long term stance, particularly on China, CPP Investments aims to build a globally diversified portfolio. It is “broadly comfortable” with how it is positioned, Walker said.

From a short-term perspective, the group is closely monitoring the political environment in light of the US election results.

“One thing that is reassuring from an investment perspective is that, looking back on global trade dynamics during prior US administration, there was a lot of noise around trade but, in the end, deals got done such as the USMCA agreement and things settled down eventually,” he said.

Rasmus Nemmoe, portfolio manager, FSSA Investment Managers, said the US economy had been very strong for many years, due partly to some great companies, but also some “one-off” stimulus measures including tax cuts in 2017 and Covid-19 stimulus, plus the increase in immigration. But he argues over the next five years or so, the marginal direction of many of the drivers that have led to strong growth in the US, are not going to be as beneficial.

“I’m not suggesting that they will collapse but, at the margin, they’re not going to be as beneficial,” he said.

“For example, it is unlikely that the US can continue with the current level of fiscal excess because there is an inflation issue. The bond market will start to react more meaningfully. Trump also got elected with an anti-inflationary mandate so a lot of the drivers that have propelled US growth don’t look as strong on a forward-looking basis.”

“Starting point equity valuations today are also significantly different to what they were six to seven years ago. The US is not a cheap place. It shouldn’t be a very cheap place, but it feels excessive right now.”

“We are probably entering a period where US growth will start to disappoint and that means the [US] dollar will potentially not be as supported, which typically favours a more positive and benign outlook for the rest of the world.”

But even with Trump in the White House, Michela Bariletti, chief credit officer, Phoenix Group, said the US was still “very compelling”.

“Trump likes his equity market and he doesn’t like to lose. The equity market is our big hope that his policies do not derail the economy,” she said.

“Trump wants to implement pretty dramatic policies and he has the power to do it so we are really questioning if the [US] institutions will survive the next four years? It’s easy to start picturing a gloomy scenario in terms of whether the rule of law and the institutions will be able to continue functioning.”

“Something that gives us hope is that Trump loves the stock market. It is very difficult to see an alternative to the US because of its size and place in passive strategies and multi-asset strategies. It’s very difficult to get out of that market. What’s the alternative?”

Salami slicing

The £47 billion National Employment Savings Trust (NEST) believes there is still a strong case for emerging markets, despite a challenging decade.

“It has been an interesting journey these past few years, particularly with China and Russia, but we still believe in emerging markets,” said Liz Fernando, chief investment officer, NEST.

“About six months ago, we were indifferent to developed markets and emerging markets in terms of our relative preferences but, from a tactical perspective, we’ve been salami slicing our DM exposure because we think an awful lot of good news has been discounted. We took a view not to do that to EM, so our relative preference is now at the margin towards EM,” she said.

Taking a longer-term perspective, NEST is rethinking the optimal way to gain exposure to emerging markets.

The fund treats emerging markets (and developed markets) as a “lump” and does not take a country-specific approach. It currently invests in emerging markets through a systematic strategy that tracks the MSCI Emerging Markets Index and has a sustainable tilt.

Fernando said the Russia-Ukraine war prompted the fund to do some soul-searching.

“We’re really questioning, just because a country is in the Index, does it automatically deserve our members’ money? Can we protect our members’ interests by avoiding markets that are going to be challenged? Also, for countries that are highly exposed to climate risk, there is a high risk of emigration which may adversely impact their ability to raise taxes and service debt,” she said.

“Over a very long-term time horizon, we’re thinking about how we can be smarter than simply including a country because it’s in the index. We’ve not come to any conclusions yet.”

Relative to global indices, University of Cambridge Investment Management, which manages the university’s endowment, has been overweight UK and emerging market equities for several years, although Sarah Wood, associate director, marketable assets, said the fund is focused on absolute returns not relative performance.

“Our mission is to consistently deliver positive returns so we try not to pay too much attention to index weights,” she said.

“I’m very confident about tilting our portfolio towards markets that reward investors for being patient.”

“On both an absolute and relative basis, the US is so much more expensive. On a valuation basis alone, we’re finding cheap opportunities in emerging markets and, because we are a relatively small fund, we’re able to allocate capital using boutique managers. We’re not limited to places with a lot of depth in the market, which is perhaps one of our differentiators.”

University of Cambridge Investment Management has around five emerging market managers, including a regional Asia specialist and country-specific specialists.

“We like this approach because every country is so different. We partner with managers that speak the language, understand the social norms and have a local presence, which gives them the information and relationship advantage,” Wood said.

According to James Fernandes, deputy portfolio manager, investment strategy at Local Pensions Partnership Investments (LPPI), positions are not managed relative to the benchmark and the LPPI Global Equities Fund’s current underweight to emerging markets is a reflection of the relative attractiveness that LPPI’s external global equity managers see.

“The overall portfolio’s quality-style bias [is the result of] where our managers have tended to find a richer opportunity set in the US and Europe,” he said.

“Over the past few years, we have generally found a similar pattern amongst our peers that share similar style biases, where we have not seen any major incremental exposure to emerging market allocations, which have typically hovered around 5-7 per cent.”

Romy Shioda, managing director, Investment Portfolio Management at CPP Investments spoke of the recent challenges investing in emerging markets.

 “Our approach to stock picking is very much based on fundamentals,” she said.

“Within emerging markets, macro and geopolitical risk have broken the tie between fundamentals and stock return, and that’s the part that makes it difficult for us to continue having conviction in our ability to make money.”

 “There have been periods of great performance, but then we see government intervention and regulatory action that suddenly puts the brakes on.

While there were companies with a lot of potential, from a quality or growth perspective, Shioda said “exogenous drivers in certain markets may impede that growth.”

“That being said, we also have managers that have done well in recent years by taking these unique market conditions into account,” she said.

According to Mike Liu, head of markets and research, Coal Pension, it is important to distinguish between emerging economies and emerging equity markets.

When it came to emerging equity opportunities, Taiwan and Korea represented a significant proportion of the opportunity set but were highly developed economies with ageing populations.

Although China was ageing too, Liu said new sectors were emerging and disrupting industries.

South-east Asia, on the other hand, enjoyed a young demographic and expanding middle class, but the public equity opportunity set was comparatively smaller.

“If we’re talking about emerging markets, it’s less about GDP growth, which historically has had a low correlation to stock returns, and more about valuations, quality and innovation in certain sectors and countries,” he said.

“With China, I’m less worried about valuations, quality or innovation but, overall, I will pay a bit more attention to the geopolitical environment such as the risk of decoupling. Some investors have been concerned about investability, though it has become less an issue more recently.”

China, India and Mexico

The outlook for emerging markets is “probably the most positive” it has been for several years, according to FSSA’s Nemmoe, citing extremely attractive opportunities in countries including China, India and Mexico.

“It’s such a diverse market. It includes some of the most sophisticated companies in the world as well as frontier companies.”

“There are always opportunities in emerging markets, particularly right now, in China and India and, on a more tactical basis, Mexico.”

Despite the noise surrounding Trump’s re-election and the potential impact on trade, Nemmoe said Mexico represented excellent value.

“Mexican assets are very cheap, both relative to historical valuations and other markets,” he said.

There are always opportunities in emerging markets, particularly right now, in China and India and, on a more tactical basis, Mexico.

“Historically, whenever there has been [trade] tension, it has been a good buying opportunity. Mexico is positioned to benefit from long-term growth drivers, including proximity to the US, reshoring and investment flowing into the country that will formalise.”

However, if Nemmoe could only invest in one country for the next 15-20 years, he would choose India.

While FSSA Investment Managers has reduced its exposure to India over the past 12-18 months, it remains “very positive” about the country, albeit “cautious”.

“India has re-rerated to ridiculous levels in many ways but it still has the most desirable long-term drivers, although capital markets have a way of pricing that in pretty effectively,” Nemmoe said.

“Things are pretty red hot right now and you probably want to stay on the sidelines. I think China is quite interesting and Mexico too, and I’d probably be a bit more cautious on India.”

Walker agreed that India looked “very expensive”.

“There’s a bunch of things on the positive side but also areas that require further development in that market,” he said.

Russia (and then China again)

Although it made investors cautious at the time, Nemmoe believes that the freezing of Russian assets that occurred is unlikely to happen to China.

“Russia is still an extracting economy and commodities are fungible,” he said. “If you applied the same sanctions on China, it’s not just China that would be impacted. The entire global economy would collapse.”

When it comes to China, NEST’s CIO is “less concerned” about sanctions and simmering tensions between China and Taiwan, and “more concerned” about the renminbi (RMB) and increasing prevalence of variable interest entities.

“A key risk is currency convertibility and controls,” Fernando said, citing the painful experience with the Malaysian ringgit in the late 1990s.

With variable interest entities, investors don’t actually own equity in a company, “they may own equity in an entity that may have the legal right to the equity exposure in the company, but it also might not,” she warned.

“The risk comes through these more left field areas where the government is trying to stamp its authority and exert control to stop people getting too big for their boots.”

The Taiwan situation was worth monitoring for Coal Pension’s Liu, given it was “one of the most sensitive issues for the US-China relationship”.

 “The question then becomes, what could trigger an escalation or de-escalation [of tensions]? This has been a so-called headline risk for over 70 years so what makes it different now?”

“In the context of the US-China rivalry, I would pay more attention to what happens in Washington DC given some hawkish members in the upcoming US administration,” Liu said.

Phoenix Group’s Bariletti said that markets tended to be “quite naïve” about geopolitical risk, adding that Russia’s invasion of the Ukraine was largely unexpected, despite decades of boiling tensions.

“I’m not suggesting it’s the same situation with China and Taiwan but I’m cautious in reading the market behaviour in terms of real geopolitical risk,” she said.

“The market tends to keep geopolitical risk on the side until it flares up. The reaction to these events have been quite benign until you get to the channel of contagion being, for example, oil prices when it comes to the Middle East.”

Liu said the market was closely monitoring situations and risks around the world but it was “almost impossible” to price the time, magnitude and duration of these potential events.

Walker said there needed to be greater collaboration between geopolitical experts and investment experts to understand how best to navigate these risks.

“The market folks like us are trying to figure things out, but geopolitical experts and investment professionals speak different languages,” he said.

Asia (including China)

As the largest trading partner for many countries, China is probably the most important player in the global value chain. In Japan, South Korea and throughout the ASEAN, China is the leading trading partner.

It’s role and importance in the region can’t be overstated, which has implications for the US, said Nemmoe.

“If you put these [Asian] countries in a position where they had to choose between China and the US, it’s not a certainty that they would still choose the US,” he said.

“The US has hard power, but does it still have the same amount of soft power it had 40-50 years ago? As we shift from a bipolar world to a multi-polar world, the US will have to navigate these changes.”

According to Nemmoe, who is based in Singapore, the future is in Asia.

“Maybe I’m biased but the vibrancy, dynamism and innovation in China and throughout South-east Asia, you don’t see in other parts of the world,” he said.

“In Asia, there are new companies and new business models popping up all the time. There are first-time users of mobile phones and the internet there, and the level of entrepreneurialism is unrivalled.”

Sustainability

Roundtable participants talked about the importance of sustainability and action on climate change but stressed that expectations differed for companies in developed markets versus emerging markets.

“We have a slightly different carbon trajectory for emerging markets because they are on a slightly different journey and it’s not appropriate to hold them to the same standards,” said NEST’s Fernando.

“We can’t divest our way to net zero so [company] engagement is critical, although it is harder to do in emerging markets, which is something we worry about.”

While NEST is a well-known institutional investor in Europe, it doesn’t have the same clout in emerging markets. Furthermore, the size of the fund’s investment in companies is much smaller, making effective engagement difficult.

“In developed markets, we talk to companies about how they do business. We might also join a coalition of like-minded investors to drive positive outcomes, but we struggle to have the same impact in emerging markets,” Fernando said.

“From a stewardship perspective, it is something we think about and we don’t have the answer.”

We can’t divest our way to net zero so [company] engagement is critical, although it is harder to do in emerging markets, which is something we worry about.

One option that NEST has considered is holding fewer companies to potentially have greater influence.

When it comes to sustainability, one area of focus for CPP Investments is improving data quality so the fund can properly measure impact and enhance decision-making processes, particularly in relation to transition risk.

“Transition-related data disclosures aren’t always great and can be subject to significant revisions so we’re working with companies to improve their reporting,” Walker said.

FSSA Investment Managers has an extensive emerging market database, dating back to 1996, which it leverages not only in the investment process but also company engagement.

Environmental, social and governance (ESG) factors are fully integrated into the group’s investment process.

“We’ve always had the view that engagement is not something that we can outsource so we developed an elaborate questionnaire and built a data bank for every company we invest in,” Nemmoe said.

“We have benchmarked best practice, which helps us identify areas to engage with businesses on. We are constantly striving to better understand how ESG and sustainability issues impact long-term investment performance.”

As an active, bottom-up stock picker, with a relatively concentrated portfolio, FSSA has developed strong relationships with business owners and management teams, which Nemmoe said is a “real advantage”.

He concluded by emphasising the importance of engagement in emerging markets, especially for investors committed to embedding sustainable principles in their portfolio.

“A big benefit of having a large team and people on the ground is that we’ll meet with management teams five times a year. That access is hard to engineer,” he said.

“Active managers have a huge role to play in driving change. We can sit down with companies and challenge them about their practices, which is pretty powerful.”