The positive market performance in emerging markets at the start of the year, buttressed by improved economic development and consumer demand, has been sidelined by institutional investors who are concerned about the broader impacts of the Russian war against Ukraine. Despite the prevailing sentiment of caution, asset owners who are considering allocations to emerging markets for diversification and return should adopt a selective and active management approach to access the compelling opportunities that continue to exist across many markets.
“Everyone is wondering about the right time to enter emerging markets,” said Devan Kaloo, global head of equities and head of global emerging markets equities at abrdn. “In general, there’s been a disconnect between the demographic dividend that’s grown in emerging markets over the past decade and investor allocations to emerging markets,” he noted, referring to the explosion of middle-class buying power in several countries. More recently, investors have been realizing that current valuations are extremely compelling and that new long-term structural opportunities in the underlying economies are beginning to present themselves. “But with Russia’s invasion of Ukraine, there has been a dramatic shift in perception around geopolitical risk that has affected investor confidence,” Kaloo said.
“We’re only partway through 2022, but it’s been quite a year already,” said Paulo Salazar, co-head of emerging market equities at Candriam. In January, as economies reopened after the spread of the Omicron variant, many investors hoped that economic growth would accelerate beyond recent trends. In addition, pent-up demand by consumers and corporates led to several central banks turning much more hawkish in moving to raise interest rates. “By early February, we saw rising yields, plus positive movement in growth stocks and long-duration assets more broadly, which triggered a lot of market rotation. Then, with the conflict in Ukraine, these prospects were downgraded,” he said.
Overall, emerging markets performed poorly in 2021, both due to the late arrival of COVID-19 vaccines compared with the developed world and the overweighting of China, which has experienced a significant economic slowdown, said Ernest Yeung, portfolio manager of the Emerging Markets Discovery Equity Strategy at T. Rowe Price. The MSCI Emerging Markets Index was down 2.54% in 2021, which ranked among the lowest of the major asset classes, he noted. “China has the largest country weighting in [that] index. Its underperformance has been a significant drag, and it has continued to struggle in 2022,” he said.
Early this year, China experienced a perfect storm with severe COVID lockdowns, a debt crisis in the property sector and regulatory tightening, Yeung said. The MSCI China Index is down 23% year-to date, as of April 22, while the MSCI EM Index is down 15% and the MSCI EM Ex-China Index is down 9% for the same period.
“China is a major reason why the index is down. In its policies, China’s government seeks political, economic and social stability — basically at any cost,” said Laura Ostrander, senior portfolio manager at State Street Global Advisors. “But overall, companies in China maintain steady earnings growth, a broadening earnings base and low valuations — and their earnings growth expectations are among the highest of the EM countries,” she said.
Investors in emerging markets note a distinct bifurcation in the asset class. On one side is China. Its zero-COVID policy and extreme lockdowns have slowed overall economic growth, said Salazar at Candriam. In addition, regulations have tightened in support of its ‘common prosperity’ policy, the debt crisis continues in its property market and there are concerns that China may move to delist American Depositary Receipts — all issues that have led to underperformance. “There has been a big drag on growth in China, much of it self-imposed. [Gross domestic product] growth in 2022 is forecast at 5.5%, but many believe they’re going to miss [the target] without effective economic stimulus,” Salazar said.
On the other side is emerging markets ex-China, driven mainly by the commodity-leading markets, he added. Latin America — especially Brazil — Saudi Arabia and, to some extent, South Africa have all benefited from the strong demand for their commodity resources. “Commodities and defensive strategies are doing pretty well.”
“There’s actually a pretty broad opportunity set in emerging markets today,” said Nick Robinson, investment director of global emerging markets equities at abrdn. “If we continue to see strength in commodity prices, these unloved, overlooked markets could benefit.”
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Among the interesting areas to watch, said Robinson, is Latin America, a region that’s been out of favor for some time. Looking back, Latin America performed well in the 2009 to 2010 commodity cycle, he pointed out. “As much as it has diversified and undergone a degree of digitalization, the markets are still very much exposed to old-economy, commodity-types of businesses.… But hidden in that market are some good opportunities from the wave of recent [initial public offerings].”
Latin America has also benefited from investor reallocations from Russia and Eastern Europe as a consequence of Russia’s invasion of Ukraine, added abrdn’s Kaloo.
The Federal Reserve had telegraphed its intentions to tighten U.S. monetary policy for some time, and it first moved to raise interest rates this March, “but as central banks in emerging markets hiked rates, some as early as the first half of 2021, they had a running head start,” said Ostrander at State Street Global Advisors. Emerging markets are much more sensitive to inflation than the developed markets, with, on average, one-third of consumer price indexes comprised of food, she said, adding that their central banks have had to be aggressive in the wake of global food and fuel prices hitting new highs.
While inflation was already running quite high at the end of last year, inflationary pressures have been accentuated by the war in Ukraine, the further disruption of supply chains via shipping routes and lower supply of commodities, said Robinson.
Since emerging market central banks moved to raise interest rates more quickly than their counterparts in developed markets, they have been very much “at the forefront of this tightening cycle, and as a result, we’ve seen inflation expectations in those markets actually begin to decline,” he said.
The first quarter of 2022 has been a time for governments to rethink energy and consumer supply chains in a more strategic way, as part of their national security, said Salazar at Candriam. Companies are also rethinking their global supply chains and moving beyond just-in-time production to be better prepared for unexpected crises. “This deglobalization process is another factor that is inflationary, and inflation is looking less transitory and more embedded every day,” he said.
Others expect that the current spike in inflation will peak and then it will settle into a somewhat steady range. “Inflation is a headwind not just for emerging markets, but [also] for the global investment environment. As we move through 2022, we expect some of those supply-chain related disruptions to ease, and inflation will start to ratchet down,” said Yeung at T. Rowe Price. “As countries prioritize national security, we will see more infrastructure development and relocation of supply chains, which will create a major spending cycle from governments and corporates. This activity will result in embedded inflation. Today, we are passing the peak, which is unlikely to sustain, but when inflation comes down, it will settle in higher than the low rates we’ve seen over the past decade,” he said.
The first half of 2022 will likely continue to be challenging, with the ongoing war in Ukraine and increasing interest rates to counter inflationary pressures. “But as we shift into 2023, we expect to see increasing investment, driven partly by renewables, stimulus in China and growing consumption overall that could lead to a phased re-entry into emerging markets,” said Kaloo at abrdn.
In addition, economic growth in emerging markets in 2022 doesn't look all that much different or better than growth in developed markets, noted Ostrander at State Street Global Advisors. “This year, we expect only a few emerging market countries to outperform the projected global average real GDP growth of 3.6%. India’s real GDP could exceed 8%, and the Philippines and Malaysia could reach 6%. But, otherwise, growth projections are muted,” she said. “Depending on how 2022 plays out in terms of monetary and fiscal tightening around the world, 2023 and 2024 could be a different story.”
Asset owners will make emerging market allocation decisions depending on their confidence that growth in these markets will outpace that of developed markets over a reasonable time horizon, said Gaurav Mallik, chief portfolio strategist at State Street Global Advisors. “If I'm invested in the U.S., which is at or above trend, do I need to be looking elsewhere? If I do see dramatic growth elsewhere, then I'll point my assets towards that marketplace. As flows start to move into EM, there is generally a gradual but steady improvement in macro conditions, earnings-per-share and return-on-equity that drives performance,” he said. “As we entered the year, we thought some of those conditions were coming into play, especially in China, which we expected would start to move from its policy-induced slowdown to creating conditions for a 5% growth target,” he said.
“Overall, emerging markets are not as stretched as other asset classes, mainly because their recovery was delayed. As [emerging market] economies continue to reopen, we expect to see better performance,” said T. Rowe Price’s Yeung. “Plus, valuations are quite low and currencies are cheap, so we believe there are absolute returns to be achieved in emerging markets.”
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“Many [investors] have asked if COVID could lead to a new regime,” he said. “But with the Ukraine crisis, our conviction has grown that we may be facing a new investment regime in the next five to ten years, because we are entering a new building cycle to prepare the world for deglobalization.”
Emerging market performance is down this year due to a number of factors. Central banks are tightening monetary policy in most countries, many are removing central bank stimulus, economic growth is slowing with the potential of tipping into recession and there has been negative investor sentiment around the Russian war against Ukraine as well as U.S.-China relations. But emerging market asset managers who are long versed in fundamental and bottom-up analysis said they continue to see countries and sectors that offer attractive valuations and strong growth potential for investors to consider when they are ready to invest.
“Right now, valuations across many emerging markets are generally fairly cheap” said Ernest Yeung, portfolio manager of the Emerging Markets Discovery Equity Strategy at T. Rowe Price.
China is the most beaten down of the emerging markets today, he noted. Investor concerns have centered around China’s geopolitical relationship with Russia, its extended COVID lockdowns and its yearlong cycle of regulatory tightening. “But actually, we’re beginning to find a lot of opportunity. When the macroeconomic outlook starts to recover and regulatory concerns fade, we expect a bid for Chinese equities, from both domestic investors, who control a lot of flows, along with their international counterparts,” said Yeung.
“In this [market environment], defensive stocks tend to do a bit better, and we see Latin America doing pretty well,” said Paulo Salazar, co-head of emerging markets equities at Candriam. Brazil, which has underperformed for some time and has also been shunned by some investors due to its volatile political situation, is showing more attractive valuations across several sectors, he noted. Its central bank is in a tightening cycle, and it’s one of the few markets in the world that has positive real interest rates.
“The Brazilian market is sensitive to commodity prices and energy, but it’s also a leader in renewable energy, where we are finding good opportunities,” Salazar said. “There are several themes that benefit from multidecade global growth trends and policy support.” They include electric vehicles, smart grids, infrastructure, advanced manufacturing and green energy. “We're also looking at pharmaceuticals and medical devices. We identify the themes first, select the companies and [then] run an in-depth fundamental and ESG analysis to identify the best stocks.”
Other markets of note include Mexico, South Africa and Southeast Asia. Salazar said that Mexico has been a good defensive play because of its close links to the growth in the U.S. economy. South Africa has more commodity-related opportunities, but it also offers good valuations in domestic consumption-related sectors and the financial technology sector, he added. Southeast Asia’s net exporters are starting to reopen and do well, particularly in Indonesia and Thailand, which are both seeing a recovery in tourism. “Valuations are attractive, and investors are looking again,” he said.
Technology and innovation continue to be major themes in emerging markets, particularly in China, which has the highest expectations for earnings growth for 2022 and 2023 compared with the developed markets. “In China, it's about localizing supply chains and manufacturing at the high end. China wants to have its own semiconductor and electric vehicle supply chains. The broad shift towards localization of supply chains will be important for EM overall,” said Laura Ostrander, senior portfolio manager at State Street Global Advisors.
Other areas of opportunities include those in e-commerce and fintech across emerging market countries. “Both [sectors] will become more meaningful over the long term, not only for the growth potential they offer, but also [for their] disruption of traditional brick-and-mortar retail and financial services functions as we move forward,” she said.
“We tend to divide emerging market technology [in China] into two buckets,” said T. Rowe Price’s Yeung. The first is recent [initial public offerings] that are growing quickly but are still not profitable, while the second is mature internet companies that generate profits and free cash flow. “Both [types] have corrected [since last year]. The mature internet companies are trading at attractive valuations, but for now the high inflation-high interest rate regime will put pressure on the newer tech companies,” he said.
“We’re finding emerging market small-cap stocks are an interesting place to be at the moment,” said Osamu Yamagata, investment director at abrdn. Since the pandemic, the MSCI Emerging Markets Small Cap Index has outperformed the S&P 500 and the MSCI Emerging Markets Large-Cap Index by a fair margin. “The reason is valuation. Many of these companies have excellent earnings growth and generate solid returns. But there’s a lack of information available, and they’re time-consuming to analyze,” he said, presenting a number of opportunities for the discerning investor. “As investors have broadly gravitated away from certain risks within emerging markets, these [small-cap stocks] have a tailwind as economies continue to reopen,” he said.
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One area of interest is banks in the small-cap space, which are focused on small- and medium-sized enterprises, especially in Latin America, Yamagata said. “With loan growth picking up, and [these banks] having managed loan provisions well, they present quite good opportunities. Some also provide digital banking, which isn’t yet reflected in pricing.”
China also offers potential in the small-cap space. “There are some well-known small-cap stocks that are helping to industrialize and automate processes, as part of multiyear megatrend themes, and they’re trading at really attractive valuations. In the small-cap sector, China’s regulatory restrictions haven’t had the same effect, so we see more opportunity,” Yamagata said. “While we’re cautious about China currently, the end of COVID lockdowns, a rate-easing cycle and healthy stimulus could happen in the second half of the year, which could create a very interesting investment outlook.”
“In the next couple of years, we could be entering a new investment regime driven by a major industrial spending cycle triggered by COVID and the war in Ukraine,” said Yeung at T. Rowe Price. Globally, national security is top of mind, which includes military and defense spending, energy security, infrastructure development and supply-chain realignment. “Globalization made the world rely on a concentrated supply chain, but we now see a need to bring manufacturing and supplies closer to home, which means building, investment in equipment and increased inventories. The markets have not fully factored that in yet.”
Whether they take a passive or an active approach on emerging markets, institutional investors today are more engaged with meeting environmental, social and governance outcomes via their investments.
Recent areas of focus include corporations’ exposure to Russia, their use of fossil fuels and movement toward the net-zero economy, as well as their treatment of workers along the supply chain. “Questions are emerging on all of those fronts around a company’s plan and strategy for these risks,” said Gaurav Mallik, chief portfolio strategist at State Street Global Advisors. “With inflation and market volatility, we thought there might be a slowdown around ESG concerns. But those economic conditions, along with the war in Ukraine and COVID, have generated even more commitment than before.”
When it comes to ESG issues, emerging market companies have tended to have a bad reputation compared with their counterparts in developed markets. “There are probably a greater number of low ESG-scoring companies in emerging markets because, as a group, they have not been as focused on ESG as companies in Europe and the U.S.,” said Ernest Yeung, portfolio manager of the Emerging Markets Discovery Equity Strategy at T. Rowe Price. “Some continue to exhibit poor ESG while others are focused on addressing their ESG issues.”
Active management is preferable in the emerging markets, Yeung added. “A basket of stocks in a passive index will include low-ESG scoring companies. This is a unique characteristic of passive investing in emerging markets. An active manager can be selective and tilt away from them,” he said.
Overall, said Yeung, emerging market governments and corporates generally have a growing knowledge and understanding of ESG factors, and ESG integration and standards are also improving overall. “We see much better ESG disclosure, and we are having much more sophisticated conversations about ESG across sectors and regions, even in heavy industry and commodities.”
“Engagement around ESG is very important, and we do a lot of proxy voting. But companies across emerging markets have really improved in terms of their understanding and disclosure,” said Paulo Salazar, co-head of emerging markets equities at Candriam. “Many of these companies provide services and products to companies that are global leaders in the developed markets. We see better standards and better practices across the board.”
“Within the ESG space, we’re moving away from the idea that certain sectors are un-investable, and we seek to drive responsible change,” said Devan Kaloo, global head of equities and head of global emerging markets equities at abrdn. “For example, industrial metals and minerals are essential to the future development of sustainable technologies. Having a seat at the table as an investor is critical in making sure those businesses are managed properly.”
“There is a structural shift in terms of capital investment and growth opportunity in a number of emerging market sectors. Climate is top of mind when we look at, for example, the solar supply chain or electric vehicle batteries,” Kaloo said. “But the opportunity set is much broader. As we look at the financial sector, financial inclusion remains a key driver for potential growth. Being able to identify those companies at an early stage and understanding how an ESG risk profile affects valuation and earnings evolution makes a tremendous difference.”
“We see emerging market allocations occurring in both active and passive, and the decision has to do with investors’ objectives. Indexed investments provide liquidity, and this feature is critical, especially in crises like March 2020,” said State Street’s Mallik. But the potential to add value with active management is much higher than in developed markets, he noted. “Across the spectrum, the regional and sector divergence, trends and themes all lend themselves to active management. We see passive allocations supporting liquidity and active providing desired alpha.”
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“We all talk about EM as though it's one homogenous group of countries and companies when it's actually completely disparate in nearly every way,” said Laura Ostrander, senior portfolio manager at State Street Global Advisors. “This becomes clear when we look at the wide dispersion of equity returns across emerging market countries: Turkey is up close to 25% in U.S. dollar terms year-to-date while Hungary and Egypt are down close to 30% — just this year-to-date. That’s a range of 55% excluding Russia, which, while no longer in the index, is down 100% year-to-date. The MSCI Emerging Markets Index itself is down 14.63% [as of April 25]. On the active side, we obviously try to do better, and the way we quantify the various qualitative attributes of companies, including ESG factors, helps to identify quality companies with long-term earnings growth potential.”
“There's a very strong case for active investing in emerging markets because they are not efficient. In general, [exchange-traded funds] can create a lot of dislocation because they allocate money despite their underlying companies’ fundamentals, so some areas become overvalued. They’re backward looking, and by the time a company is included in an index, it’s at the top of its valuation, so you miss most of the growth,” said Salazar at Candriam. While passive funds are a representation of the broad market, they own the bad stocks along with good. “Most of our excess return comes from stock picking, and to thrive in emerging markets, you need an ability to adapt to different environments and adjust to new conditions.”
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