What route is right in emerging markets investing?

Emerging markets (EM) equities offer investors the potential for high growth as well as diversification, but accessing the right opportunities can be challenging. As an asset class, EMs can be both opaque and volatile, tending to be less efficient and homogenous than developed markets (DMs) and more vulnerable to geopolitical risk. Escalating US/China tensions have further dampened enthusiasm for EMs, especially in light of a Chinese post-COVID recovery that many investors have found underwhelming. Yet attractive valuations and lower inflationary pressure relative to DMs are among a number of forces contributing in our belief to a compelling outlook for EMs, provided investors can successfully surface the right opportunities. But how? 

Investing in the structural development of emerging economies may represent an alternative approach. A focus on the long-term growth potential of multiyear structural forces, rather than individual countries, sectors or regions, may be less correlated to traditional economic cycles. These forces are changing the world around us and may be supported by government policy, demographic shifts or technological advancements.

What is the economic development opportunity?

Identifying structural shifts relies upon our ability to establish the long-term direction of change. We believe that policy focus is increasingly shifting towards a more inclusive, innovative and sustainable economic model and that “next generation” economic development looks quite different from traditional ideas of growth. In our view, growth 1.0 had three key hallmarks. It was characterised by concentrated growth — few but large winners. Environmental neglect was an unfortunate and uncosted byproduct. And globalisation drove down costs, leading to larger supply chains and cheaper labour and capital. In contrast, we think next-generation economic growth/development is more inclusive, as the base of beneficiaries of economic progress broadens. The emergence of ESG and the impacts of climate change will see a new emphasis on sustainable growth. Finally, as globalisation unwinds, pressure to increase efficiency in manufacturing and service sectors will reward innovative solutions to problems.   

This vision of a more inclusive, sustainable and innovative future helps shape a road map for investors and, in our view, is particularly relevant within EMs. We expect a certain degree of complexity to persist within EM investing, but the use of this structural lens helps us see clarity in a number of stories. What’s more, the EM context itself may serve as a driver, for several key reasons:

A big focus of the next decade will be on green technology and science-based industries such as high-end manufacturing. EM is a diverse asset class, and despite the slowdown in China, many other EM countries could see growth accelerate, which will drive relative earnings and market share. 

Another driver is demographic change. Emerging markets account for 82% of the world’s population but currently only 26% of global market cap¹. A younger demographic and an expanding middle class could drive increased revenue for companies through premiumisation and the increasing adoption of progressive technology.

Deglobalisation has meant that supply chains are diversifying fast as they look to become more self-reliant and less dependent on China. Countries with relatively low wages but skilled workers or access to advanced technology — such as India, Indonesia, Thailand, Vietnam and Mexico — are benefiting from this supply chain diversification.

Digitisation and infrastructure development may have an advantage in EM. Emerging markets have fewer legacy issues than DMs when building new infrastructure. This confers an advantage when building smart cities, 5G networks and transport networks. The same goes for EV development and future consumption.

A closer look at the economic development opportunity in practice 

These drivers may result in powerful investment opportunities, but it’s important to remember that themes best exhibit their potential over the long term and diversification over shorter time periods is critical. For this reason, it can be beneficial to focus on a range of themes, rather than one or two. The following examples serve to illustrate these differing time horizons in action. 

What we are excited about– One of the areas we believe to be particularly compelling within the EM economic development opportunity is social empowerment. This aims to invest in the enablers of social mobility and includes consumer lending, education providers and telecommunication companies. This structural opportunity tends to be diversified across industries with exposure to some companies that are more defensive in their orientation, such as wireless telecom companies critical for digital inclusion initiatives. In addition, it has benefited from a resurgence in education-oriented companies in Latin America with strong business models and, in some instances, renewed policy support (for example, in Brazil).

What we’re keeping an eye on – Environmental consciousness and energy efficiency are two further structural themes where we see potential opportunity, but more recently have been hit by macroeconomic factors. As the global leader in renewables investing, China is a particularly rich source of investment opportunities within these themes. This remains the case even when other growth drivers in China are experiencing a slowdown, highlighting the importance of understanding the future drivers of sustained growth. The electric vehicle (EV) market presents a good example of this in practice. While Chinese original equipment manufacturers (OEMs) have historically struggled to gain foothold both globally and within China, the transition to electrification is empowering their entry into the EV market. Chinese OEMs have steadily developed capabilities, built strong and deep supply chains and are now the largest EV makers globally. With a compelling and affordable EV proposition, we see a long runway for both local and international growth for Chinese OEMs.

Improving the odds of success

While EMs can offer the potential for powerful investment opportunities, they also have a higher risk profile than DMs. To help counter this, we believe there are some additional important considerations for investors. 

Risk management is a crucial discipline when investing in EM. We believe bringing an institutional rigour to risk management helps capture opportunities while ignoring market noise. 

Targeting a variety of themes, rather than one single theme, can help maximise diversification and risk-adjusted returns. 

Sustainable, inclusive and innovative economic development has, in our view, a natural overlap with ESG. As an extension of this belief, we think that the better we understand ESG issues, the more informed our investment decisions will be. Nascent and disparate ESG coverage in the EM space often leads to company mispricing, creating opportunities for active ESG research. In our view, ESG integration can be both return-enhancing and risk-mitigating. 

Aligning fundamental, bottom-up research with thematic investment helps identify potential winners from each structural theme. 

Given the extent to which the market underappreciates economic development's impact on profit pools, a thematic approach may offer the potential for above-average returns. However, as with any investment theme, implementing this approach requires deep research and expertise in not only identifying the right long-term trends but applying a disciplined approach to risk management. A nontraditional approach to EM, focusing on economic development via a theme-based approach, may offer a differentiated way to access the potential of EM without the constraints of backwards-looking benchmarks.

¹ Source: Bloomberg