Over the last ten years the emerging markets have lagged significantly behind their developed market counterparts, but there are signs that this may be about to change. The recent revival has partly been driven by dollar weakness, and if this continues as many expect, it could herald a third major period of EM outperformance.
Recent analysis by JPMorgan suggests that crises lead to secular shifts in market returns. They point out that the bursting of the dotcom bubble in the year 2000 marked the end of the dominance of US growth, with the following decade being a period of relative strength for value, emerging markets and European equities.
There was then another major shock in the form of the global financial crisis, after which the pendulum swung back in favour of the US and growth stocks. We could now be on the cusp of a further significant change as the emerging markets lead the way out of the pandemic.
If this turns out to be the case it would mark the third wave of EM outperformance with the others being the decade from 2000 to 2010 and the six years from 1988 to 1994. Such a scenario would have profound portfolio implications and require investors to increase their allocation to the region.
To put the scale of the opportunity into context, over the ten years to the end of 2020 the MSCI emerging markets index underperformed MSCI World, its developed markets counterpart, by an average annualised return of just over six percent per annum. It now trades on a forward price-earnings ratio of 15 compared to 21 for MSCI World.
Adrian Lowcock, head of personal investing at Willis Owen, says that most emerging markets couldn’t afford to close their economies during the pandemic as we did in the west and they have therefore stayed open.
“This means the economic impact of the global slowdown in demand is more limited and as it picks up EM will rebound,” explains Lowcock. “If tensions between China and the west ease that should also benefit the region.”
Ben Yearsley, a director at Shore Financial Planning, says that he is a big fan and thinks that Asia and the emerging markets will be in for a sustained period of outperformance.
“EM starts this year relatively cheap compared to the developed markets, yet has better demographics and debt and has handled Covid better than many countries,” says Yearsley. “Over the next decade there will be two billion more people in the global middle classes with many expected to come from EM and Asia.”
In absolute terms emerging markets look like they have performed pretty well in recent years, but they have been left trailing by the US over the last decade. The gap has narrowed slightly since the market turned in the depths of the pandemic, largely because of the hope that China has come out of the other side of its lockdown and will drive growth higher.
Ryan Hughes, head of active portfolios at AJ Bell, says that the emerging markets have a fantastic opportunity to provide the engine room for growth for the global economy for many years to come.
“With low levels of debt, younger populations and governments mainly set on making their countries more attractive locations to do business, places such as China, India, Mexico and Indonesia have great long-term growth prospects that will see many of their domestic companies grow rapidly in the coming years,” argues Hughes.
Recent analysis from the Centre for Economics and Business Research suggests that China will have a larger economy than the US in just seven years’ time, while India will be the world’s third biggest economy by 2030. This represents a staggering rate of growth that will completely change the balance in world economics.
Darius McDermott, MD of Chelsea Financial Services, says that they like Asia at the moment, particularly India and countries such as Indonesia, Vietnam, the Philippines and Thailand, where they have good demographics.
“Latin America has struggled and has had a difficult time battling the virus, but is very cheap,” notes McDermott. “It’s risky, yet has the highest potential to bounce back. Russia is also very cheap but risky, as ever. There is also the possibility of new sanctions.”
Another factor in the emerging markets’ favour is the weak dollar, which is expected to remain under pressure due to the massive amount of money printing (quantitative easing) taking place in the US. This is good for many EM countries as they often find it easier to borrow in dollars rather than their own currency, so the weakness makes servicing the debt easier and cheaper.
“In recent years, dollar strength has held back some EM countries and caused major economic turmoil, but if this turns into a tailwind, it could provide a real boost for them,” says Hughes.
It is a mixed picture though. A weak dollar would be good for places like India that imports all the oil that it uses as it makes it cheaper for them to buy, but it is not so good for exporters in the region as it makes their goods more expensive on the international stage.
“The positive impact of a weaker dollar will vary on a company-by-company basis, but it should be particularly positive for commodity-dependent countries in Latin America and Africa where they have significant exposure,” explains Lowcock.
The bigger picture
A weaker dollar would make Chinese exports to the US more expensive, yet the country is going through such a rapid transformation in favour of domestic consumption that the impact might not be as significant as it would have been in the past.
“The emerging markets consist of more than 60 countries with varying fundamentals, different economic growth patterns and often widely diverging company valuations, but when you invest in an EM index, you have to be aware that China dominates, so if it disappoints it can have a big influence,” warns McDermott.
China represents around 40% of the MSCI EM benchmark and so far it has managed its growth trajectory reasonably well, but some people are starting to worry about the level of debt in the country and some kind of debt default at a local level would hit confidence hard.
“The Chinese government is going through a period of reform of its financial system as demonstrated by the last-minute cancellation of the stock market listing of Ant Group,” remarks Hughes. “In many ways this is a positive as it shows they are taking financial stability seriously, yet it is a reminder that the government has a very heavy hand and can act quickly.”
Political reform continues to play a big role in the attractiveness of the emerging markets as a long-term home for capital, but it is a difficult process as evidenced by the recent problems in Brazil, South Africa and Turkey.
The best funds and trusts
Hughes says that for core exposure it is worth looking at Fidelity Emerging Markets, which he describes as a good growth fund with an experienced manager who is supported by a large team of analysts across the world to help find the key opportunities.
“Manager Nick Price looks for those companies that have high earnings, relatively low debts and a strong degree of resilience. The fund has a large exposure to China, while Korea, India and Taiwan also feature heavily with big positions in technology companies like Taiwan Semiconductors, Samsung and Alibaba.”
Lowcock is another advocate and says that Price’s investment process is based on a deep analysis of a company and its accounts. The resultant portfolio shows clear biases to growth and a higher return on equity compared with the index.
“I also like Somerset Global Emerging Markets and admire the manager’s refusal to get involved with momentum driven stocks with weaker financials,” says Lowcock. “Somerset is a specialist boutique with a close-knit team, in which the employees own a stake in its success, which is wholly dedicated to emerging markets with research coverage extending across the market cap range and including frontier markets,” he says.
McDermott prefers GQG Partners Emerging Markets Equity, which is managed by one of the newest and fastest growing asset management businesses, having only launched in 2016.
“Rajiv Jain, the founder of the company and lead manager of this fund, has 25 years’ investment experience. It is a concentrated portfolio of high quality companies with durable earnings and an emphasis on the future quality of earnings.”
Another option courtesy of Yearsley is Matthews China Smaller Companies, which he describes as a fascinating fund playing on the domestic theme. He says that it is a really exciting prospect as the domestic story has a market of 1.5 billion potential customers with technology and healthcare forming a major part of the portfolio.
In a similar vein he also likes Alquity India, which is playing the domestic theme in India, a country with a market of more than one billion potential customers. ESG is at the heart of the firm’s investment process and this helps to set them apart.
The broker Numis recommend the JPMorgan Emerging Markets Trust (LON:JMG) – see fund of the month below − as their core pick in the sector, but have recently added Templeton Emerging Markets (LON:TEM) as a trading buy on account of the eight percent discount to NAV.
Since Chetan Seghal was appointed lead manager in February 2018, the trust has built up a strong track record driven by stock selection and sector allocation. He and his colleagues aim to capitalise on the long-term structural opportunities by investing in companies with sustainable earnings power that are trading at a discount to their intrinsic value.
The pandemic was a major shock to the global economy with the emerging markets coming out of it in better shape than the west. If the dollar weakness persists as the world recovers it could herald another major period of outperformance as these younger, more dynamic economies embark on the next phase of their development.
FUND OF THE MONTH
The £1.7bn JPMorgan Emerging Markets Trust (LON:JMG) focuses exclusively on companies, rather than countries and is backed by one of the largest EM research teams available to investors. It has been run by Austin Forey for over 25 years, which is a significant advantage for the portfolio given his experience of managing the vehicle through numerous crises in the region.
“Forey has delivered excellent returns for more than two decades, emphatically demonstrating that his long-term approach to stock-picking has been successful, while also being able to evolve the portfolio to meet changing trends,” explains McDermott.
There is a strong focus on growth stocks with about a quarter of the fund in technology companies, although it is now underweight China. It had previously been overweight and made excellent returns from its big exposure there, but is currently finding better opportunities in India.
“The trust is focused on large cap stocks and has nearly ten percent in Taiwan Semiconductors, showing that the manager is prepared to invest with conviction. It rarely employs gearing to any great degree and is trading at a tight one percent discount, indicating that investors value this approach highly,” says Hughes.
Over the last five years the JPMorgan Emerging Markets Trust has made an average annualised return of 22%, which is comfortably ahead of the 18% achieved by the MSCI emerging markets index.