Mike Hollings, Partner at Shard Capital
The term “Emerging Markets” was first used by an IFC economist in 1981.
It certainly qualifies as an understatement to say that, over the last 42 years, much has changed globally in terms of an economic, political and social perspective.
The Morgan Stanley Emerging Market Index contains around 1,420 constituents, however just 5 countries: China (29.5%), Taiwan (15.6%), India (14.6%), South Korea (12.3%) and Brazil 5.5%) accounts for over 75% of the Index. Of these China now accounts for about 17.1% of Global GDP with India coming in at around 3.2% currently, (slightly ahead of the UK at 2.8%), hardly “emerging market” metrics.
It is clear that economically, if not politically, the top 5 constituents of the MSCI “EM” Index can no longer be described as “emerging”, as they are all major contributors to global GDP, and who play an important role in ensuring that global growth potential is achieved within an optimal inflationary/deflationary framework.
One of the benefits of investing in emerging markets is the diversification it offers given the widely differing economic growth rates across the countries involved as well as clearly differing social and political risks. That said, and in contrast to most major developed economies, many of the countries within the “emerging markets” enjoy very favourable economic tailwinds including: positive demographics, growing middle class with increasing disposable income, low levels of personal debt and also pension systems that are embryonic but growing strongly.
So, what are the risks?
There are obviously many risks associated with investments in emerging markets, but as pertains specifically to EM we would say the three major risks are i) political risk and ii) FX risk and iii) liquidity risk.
Whilst these are some of the major risks in EM they can, counterintuitively, sometimes help create attractive investment opportunities because investors, almost inevitably, often over-react to these perceived risks.
Current Investment Opportunities
EM have performed well this year based on three broad trends: i) a continuing move away from the US$ as a trading currency, ii) a move to re-shore supply lines away from a dependence on China and iii) a structural bull market in commodities due to years of chronic underinvestment.
Drilling slightly deeper into opportunities we favour:
- India: India has been a major beneficiary of asset re-allocation away from China. Its economy is growing at just over 6% p.a and inflation is beginning to head lower, allowing the RBI room to adopt more dovish monetary policies. Whilst equity valuations are elevated, growth potential at least justifies higher multiples. In a world where many investors believe the West is facing a slowdown and at worst a recession, any market which can provide evidence of realistic growth prospects over the longer term, is going to command interest. However, for investors worried about current Indian equity valuations then Indian Govt bonds might offer attractive risk reward characteristics particularly with the Indian Rupee trading close to all-time lows vs GBP.
- Latin America: Latam markets have done very well this year with Mexico in particular faring well from the “re-shoring” theme. That said we think structural underinvestment in commodities over the last few years means that Latin America should be well positioned to benefit from higher commodity prices as the Fed approaches the end of its tightening cycle and the US$ at least pauses for breath, if not continues to head lower.
- Asia Pacific Consumers: Asia Pacific is home to a growing demographic of rising middle class with increasing disposable income. Countries like Indonesia, Vietnam and Thailand stand out as good long-term beneficiaries of demographic trends. Interestingly we believe this theme allows investors to participate both via equity exposure and fixed income exposure.
EM markets to avoid currently
We noted that China is the world’s second largest economy and accounts for close to 30% of the MSCI EM Index. For a long-time exposure to China was almost “a given” for most global investors.
However, over the last couple of years that has changed and for two main reasons.
Firstly, a crackdown by the Chinese government, which began in November 2020, and which targeted many of the large cap tech companies, made investors reassess and question the safety of investments in China. Secondly, the global lockdown caused by Covid laid bare to many, including the US, just how dependant their economies were (and still are) on China causing them to begin moving production centres out of China.
On top of these two headwinds China has had a very laclustre re-opening from Covid and investors are rightly concerned about the level of NPL’s lying within Local Govt Financing Vehicles. This has caused the Govt to put pressure on Chinese banks to adopt extremely “creative” approaches to rolling non-performing loans.
Taken in conjunction the foregoing surely indicates that China will continue to struggle generate any real growth this year and will in fact revert to being an “exporter” of deflation to the global economy, which may not be a bad thing for the rest of us, but will add social pressure domestically.
Ways to gain exposure to EM markets or Themes
For investors looking to access emerging markets it is probably best to do so via either ETF’s or Funds given that issues related to i) time difference, ii) local currency issues, iii) foreign ownership limits, iv) custody issues etc make direct investment very difficult.
Funds we recommend:
Given relatively high equity valuations in India currently a potentially “safer” way to gain exposure (with a putative margin of safety built in) would be the J P Morgan Indian Investment Trust which currently trades on an 18% discount to stated NAV. In fairness the Trust has traded on a discount for some time (average discount over 5 years is 15% according to Bloomberg data), but it does provide good proxy exposure to the Sensex Index. For investors looking for a more focused, and therefore potentially more volatile, exposure to the India growth story the Ashoka India Equity Investment Trust has produced consistent outperformance over the last 5 years.
As regards exposure to Indian Govt bonds the L&G India Govt Bonds UCITS ETF provides GBP exposure (unhedged) to a portfolio of Indian Govt bonds with an indicated duration of around 6.5 years and a dividend yield of 6.3%. This would be primarily an FX play, but with the Indian Rupee close to all-time lows vs GBP, and with the UK inflation seemingly headed lower allowing the BOE to hopefully start cutting rates next year, the risk reward looks attractive to us.
We also recommend the Prusik Asian Equity Income Fund which has an impressive track record vs the MSCI EM Index, particularly during periods of volatility. As an example, last year, in GBP terms, the Prusik Asia equity Income fund was +14% vs MSCI EM Index -14%. The fund pays an annual dividend of around 6.3%.
In Fixed Income we recommend the Muzinich Emerging Markets Short Duration fund. Last year the fund managed downside risk very well. In GBP terms it fell only -8% over the period vs -15% for the Bloomberg EM Hard Currency Bond index The portfolio currently trades on a duration of 1.7 years with an indicated yield of 4.3% in GBP.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are his own and do not constitute financial advice.
