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Investment opportunities in Emerging Markets

In the past when investors considered Emerging Markets, they have been wary because things like pot holed roads, cheap plastic toys and corruption have often sprung to mind. However, this mind set is changing.

Economic growth in some Emerging Markets is faster than growth in many advanced economies and, more billionaires are being created in emerging economies than developed ones.

With most of the world’s population housed in emerging markets, most of which are very rapidly becoming consumers, we are probably on the cusp of a high octane new industrial revolution on a scale the world has not yet experienced.

Asia has a major role in the emerging spectrum, powered by the twin powerhouses China and India but healthy growth in smaller economies has also contributed to Asia’s surge.

Nevertheless, historically many investors have favoured a home-country bias, tilting their allocations towards what’s familiar. However, through greater education and opening of minds and borders, this bias is shifting and enabling opportunities for investment because companies are no longer being viewed purely on their current status, but how they might look in five to 10 years from now.

Emerging market countries are potentially better positioned today to withstand increasing funding costs of debt, as a result of improved external imbalances and a more stable debt profile.

Furthermore, public debt levels in some emerging market countries could be said to look more favourable when compared to developed markets.

But how can investor’s best enhance investment opportunities across the equity, debt and small cap spectrum?

Economic growth vs stock market returns

Firstly, it’s important to consider the relationship between economic growth and stock market returns. This can throw up many questions on the foundations of strategic asset allocation; how managers (and consultants) derive expected returns; and country versus company influences.

Many managers claim to be benchmark-agnostic, but often Emerging Markets managers are making mere tilts away from the benchmark index rather than genuinely independent portfolio construction. The index benchmark is the opportunity cost regardless of whether the manager likes the index or not.

When it comes to addressing the question of stock markets’ relationship with economic growth, generally stock market wealth has followed emerging economic growth, with the notable exception of China. For post-industrial, rich nations, the theory is no longer relevant. But even in emerging markets, there are complicating factors.

For example, over the last ten years the GDP of Emerging Markets has doubled but investors could be robbed of years of bountiful returns by currency falls overnight.

One way to better align investments with GDP was to cast aside the benchmark and concentrate on countries and companies that followed the “well-trodden path” of secular socio-economic improvement.

Anomalous classification

Investors need to consider the anomalies in classifying Emerging Markets too.  Samsung is a popular example of the anomalies in classifying Emerging Markets. South Korea is ranked the 11th biggest economy globally but somehow not a Developed Market according to index providers.

This puts the relationship between GDP and stock market returns back into focus. Analysing the likes of Samsung does not involve political risk but instead very much the dynamics of the relevant global industry.

On the other hand, looking at a Frontier Market like Rwanda, where there are potentially only two stocks to invest in – a brewery and a bank – then the macro conditions account for at two-thirds of the influence on stocks.

The smaller the stock exchange and its constituent stocks the more the influence of macro- economics.

However, one myth that no longer stands is that foreign investors need to be in the market to make it investable. A far more relevant criterion is local bank rates. For example, if locals are getting 15% for money on deposit, then there is not much incentive to equity investing. But as rates come down then equity markets re-rate upwards.

This this is why debt can be a more attractive way to play Emerging Markets. Over time, Emerging Market equities and debt have delivered similar returns but said there is a compelling entry-point to Emerging Market equities today after a decade of poor returns relative to developed markets.

Buying in China

Despite a recent slowing down of the Chinese economy, China continues to have one of the fastest rates of economic growth in the world, adding the equivalent of “another Australia” each year[i]. But investors need to be aware that China is an anomaly.

It’s a country where equity investors have not enjoyed great returns commensurate with its economic growth. The narrow Chinese equity index performance has been lacklustre because the Chinese government has only permitted foreign investors to buy into a select, few State-Owned Enterprise stock, not the guts of the economy.

This is a market where appointing local specialists is key, as local knowledge is essential to invest wisely in China and avoid the pitfalls. Local retail investors dominate en masse and even mutual funds, supposedly run by professionals, behave like retail. This makes for a momentous market.

Some predict that the future for China is select – but perhaps not with those companies currently investable. Looking at FANGS (Facebook, Amazon, Netflix and Google, now Alphabet, Inc.), they have drawn capital from Emerging Markets. Only China can follow that U.S. model.

In the future it is possible that about ten companies, championed by the government there, will draw all the money. China, like Japan before it, is therefore likely to then merit its own allocation (and index) within capital markets in the future.

Whatever the future holds, no other country is poised to have as much impact on the global economy over the next two decades according to the World Bank[ii] who suggest that even if China’s growth rate slows as projected, it would still replace the United States as the world’s largest economy by 2030.

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