InvestmentsMar 31 2021

Income-seeking investors cannot ignore EMs, managers say

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Income-seeking investors cannot ignore EMs, managers say
Photo by Zhang Kaiyv via Pexels

Long-term investors seeking income for pension portfolios should consider the growth of dividend-paying companies in the emerging market indices, managers have said.

Moreover, the potential for several countries to grow their way out of the various emerging market indices over the next decade and into the developed market indices, presented an opportunity for long-term investors, they added.

Andrew Lister, manager of the £371.3m Aberdeen Emerging Markets Investment Company, and Ross Teverson, head of strategy, emerging markets, for Jupiter Asset Management, said investors should make sure they have exposure to EMs within their portfolios. 

Lister said: "The outlook for income from emerging markets is promising, as there are a many companies in a wide spread of different countries and industries that generate cash in a range of currencies and then distribute dividends, offering genuine diversification.

"This is a real contrast to the UK market, where the experience of income-oriented investors has been extremely challenging of late and where the risks remain linked to a relatively narrow group of companies."

According to iShares, the MSCI Emerging Markets index is producing an approximate dividend yield of 1.41 per cent. This compares with 3.11 per cent for the FTSE 100 (as at March 31, 2021).

However, as UK companies have been curtailing dividends while many EM companies are starting to pay dividends, the opportunities for growth over the decade looks strong in emerging markets.

China faces the same challenges of indebtedness and an ageing populations that most developed markets face.Teverson

Lister acknowledged that emerging markets can be perceived as too risky for more mature investors who are typically those seeking dividend income, but added: "We feel this is a gross oversimplification".

He explained: "Having emerging markets in the mix for income oriented portfolios is essential in my opinion, and this extends to bond markets, as well as equities.

"It’s with this in mind that we have an allocation to Chinese and frontier market bonds [within the investment trust], as we feel the potential returns are similar to equities, but with significantly lower volatility and correlations to other asset classes than one might expect."

Candidates for reclassification

Both managers said certain countries were ripe for reclassification, such as Poland, China, South Korea and Taiwan over the next 10 years, thanks to the maturity of many companies listed on their stock markets. 

Indeed, more than 10 years ago South Korea was upgraded by S&P and FTSE Russell, while Poland was upgraded to developed market status by FTSE Russell in 2018.

Teverson commented: "With GDP per capita in terms of domestic purchasing power parity now close to that of some Western European economies, Poland is a candidate for reclassification." He said he expected the MSCI would upgrade it by 2030.

According to the International Monetary Fund, Poland's Projected Real GDP growth for 2021 is 2.7 per cent. This compares with 4.5 per cent for the UK and 3.5 per cent for Germany.

Should Poland strengthen its GDP in line with Eurozone and continental European economies, the possibility of its upgrade becomes more certain.

Being on the right side of such changes can be rewarding in the short term, but shouldn’t be the driver of a long term strategy.Lister

However, as Teverson explained: "The upgrading of a country from emerging to developed market status is a relatively infrequent event. The last time MSCI upgraded an emerging market was in 2010, when Israel was reclassified to a developed market."

Moreover, even South Korea - which is home to global brands such as Samsung Electronics and Hyundai Motor - will need to have further reform and liberalisation of market access before the country could be reclassified by MSCI. 

That said, Teverson said this could certainly happen before 2030.

Lister added: "It is reasonable to expect the likes of China, Korea and Taiwan, which currently make up two thirds of the EM Index, to be candidates for reclassification as developed markets, based on their size, economic growth and rising GDP per capita.

"Changes to such large components of popular benchmarks obviously prompt substantial flows of capital, both active and passive, which would undoubtedly have to be completed in a phased fashion. 

"Being on the right side of such changes can be rewarding in the short term, but shouldn’t be the driver of a long-term strategy. "

Potential drags

Earlier in March, China held its annual National People’s Congress, during which the government said it was targeting 'above 6 per cent' GDP growth this year.

This is down on the 8.1 per cent predicted by the IMF in January this year, but still outstrips that of the UK, the US and the European Union. 

Add to this the strength of China's stockmarket, which emerged well in 2020 after the global lockdown caused by Covid-19, and it does currently present itself as a front-runner for MSCI reclassification over the next decade. 

However, there are potential drags on its performance for long-term investors, which both Teverson and Lister have outlined.

One long-term consideration for UK investors will be China’s weighting within emerging markets. China’s concentration in the benchmark is approximately 40 per cent of the MSCI Emerging Markets Index.

Teverson said this could become problematic "in the event Chinese equities enter a more challenging period, which is possible, given the country’s high levels of aggregate debt and elevated valuations in certain parts of the market".

In this case, investors may come to question the wisdom of having such a high single-market concentration in an asset class that extends across 27 countries.

This is reflected in the current sector allocation of the Aberdeen Emerging Markets Investment Trust, where Lister's weighting to China is at 31.9 per cent of the portfolio, compared with 39.5 per cent in the MSCI Emerging Markets benchmark index.

Teverson added: "China, while being home to many well-run and globally competitive businesses, faces the same challenges of indebtedness and an aging population that most developed markets face.

"In time, investors may come to question whether China’s high concentration in emerging market benchmarks comes at the expense of exposure to markets that have far more potential to 'emerge'."

Simoney.Kyriakou@ft.com