However, EMs still offer value for investors.
Rising trade tensions have prompted a cautious investor outlook, but in our view the market reaction has been excessive. In recent years, intra-EM trade has become more important and rising protectionism could further turn focus towards more regional agreements.
For example, the long-term growth of intra-Asia trade is centred on China as the country transitions to a consumption-based economy, opening up new opportunities for trade in Asia.
We believe trade disruptions would only impact China in the short term and may help speed up China’s efforts to upgrade its economy with additional investment in the service and higher-value added manufacturing sectors.
These countries with strained finances continue to attract the bulk of headlines, but it is worth noting their relatively small size in the context of the broader emerging markets asset class.In our opinion, what has been hurting sentiment is not trade policy itself, but continual trade tensions and uncertainty. We believe businesses can adapt and develop long-term strategies around trade policies once there is greater clarity.
We aim to look beyond the ‘noise’ of negative news headlines and instead focus on the underlying fundamentals of the EM asset class.
While a few countries such as Argentina and Turkey may have skewed overall investor perceptions, we believe many EM currencies are attractively valued and well-supported after recent downward moves.
Key points
- Emerging markets suffered a setback in the first half of 2018, on the back of trade tensions and rising US interest rates
- Negative sentiment on emerging markets is overplayed
- Emerging market economies have been shifting to ‘new economy’ industries
These countries with strained finances continue to attract the bulk of headlines, but it is worth noting their relatively small size in the context of the broader emerging markets asset class, as well as the extent to which their fundamentals are weaker. For example, Turkey represents only 2 per cent of the MSCI Emerging Markets Index, Pakistan 0.5 per cent and Argentina is not even in the index yet.
We also consider fears regarding US dollar strength to be overblown.
Short-term risk aversion and a slight upward move in the US interest rate trajectory have contributed to the dollar’s climb, but we do not expect these drivers to be sustained over the long term.
It is important to remember that not all emerging markets will be hurt by the same factors, and individual market performances vary considerably.
As stock pickers, we can choose among the varied opportunities that emerging markets offer to build well-diversified portfolios that seek to avoid excessive risks.
Drivers for growth
Asia so far has stood out for several reasons: structural growth in the technology sector; rising consumption; and economic reforms in countries such as China and India.
In China, supply-side reforms and deleveraging could help ease structural risks, but rising trade tensions could offset the benefits of stronger global growth. We are also positive on countries such as Taiwan and Thailand, where macroeconomic data remains healthy.
In Europe, Russia stands out as one of the most undervalued markets in the region, as well as the EM universe as a whole.
After two consecutive years of contraction in 2015 and 2016, the Russian economy returned to growth in 2017, supported by consumer demand and a rebound in commodity prices.
Although economic sanctions have affected the market, because the Russian economy is less dependent on the West and is more self-sustained, it is still possible to find companies that are able to flourish and do well. It is also important to note that corporate governance of many Russian companies has also improved significantly.
In Latin America, a cyclical rebound is taking place amid the commodity price recovery, but political uncertainty due to elections may result in increased volatility in some markets.
The EM universe has also expanded in the past few years with the inclusion of markets previously classified as frontier (such as Qatar, the UAE, Pakistan, and Saudi Arabia).
Many investors continue to view commodities as the dominant driver of emerging markets, however this a misperception.
Commodity production and export remain important to certain economies, but emerging markets as an aggregate have been shifting towards ‘new economy’ industries underpinned by innovation and consumption, and the influence of commodities has waned over the past decade.
Technology has now become an integral part of the EM story, having an impact on many sectors. We feel that emerging markets are embracing different technologies, which continue to drive growth and earnings. Meanwhile, rising disposable incomes should continue driving demand for goods and services.
We continue to favour companies that stand to benefit from structural trends such as e-commerce, growing affluence and premium-isation. Financials are also interesting to us, as improving macroeconomics in emerging markets create a potential tailwind for banks.
Macro backdrop
The case for emerging markets remains intact on the back of a supportive global macro backdrop, higher GDP growth, improving economic fundamentals supported by ongoing reforms, coupled with an improving earnings outlook and attractive valuations.
Additionally, cash flow generation has accelerated considerably in recent years, which, when paired with better capital allocation discipline, improves returns to shareholders and results in corporate balance sheet deleveraging. Earnings growth has also been resilient, while valuations have become cheaper during this period of market volatility.
Overall, emerging markets are operating in an environment where commodity prices are stable, inflation is under control in most countries, and local currencies, in general, appear undervalued.
In our view, many investors remain considerably underweight to emerging markets, which is supportive of further rerating.
Historically, emerging markets have bounced back from external shocks, displaying resilience through the years.
All in all, the case for investing in emerging markets remains strong and they could offer exciting long-term investment opportunities for investors willing to navigate the current market uncertainty.
Chetan Sehgal is lead portfolio manager of the Templeton Emerging Markets Investment Trust
