Can emerging markets have a role in an income portfolio?

Tom Kynge, portfolio analyst at Sarasin and Partners, says a feature of emerging market equities in recent years has been that it is the most defensive parts of the market that pay an income.

He says: “Emerging market equities also screen as good value from a dividend yield perspective when compared to developed markets.

"Traditionally, using an equity income style in emerging market can be seen as a relatively defensive way of gaining access to emerging market equity risk. This strategy has been relatively successful over the past decade given the bias towards higher-quality companies that are less likely to use leverage.”

Kamil Dimmich, emerging market equity investor at North of South, acknowledges that it is somewhat counter-intuitive to think of emerging markets as central to an income investment portfolio as economies and companies that are described as 'emerging' should have the bulk of the their growth ahead of them, rather than now, and so it would be a smarter use of the capital generated to deploy it on ensuring that future growth opportunity is captured, than on paying out in dividends today. 

Emerging markets are at different stages of development, and so should not be treated the same way.Arun Sai, Pictet Asset Management

This general view of the merits of growth companies, in any jurisdiction was summed up by James Anderson, the former managing partner at Baillie Gifford, who described dividends as “being what happens when a company runs out of ideas.” 

But despite this view, Kimmich actually launched an emerging markets income fund last year.

Explaining the rationale for this, he says: “Governance among emerging market companies is improving, and therefore so is the propensity to pay dividends. It is much improved on five to 10 years ago. Companies in places such as Taiwan have big cash piles now.”

Apples or pears? 

Jonathan Toub, a fund manager at Aviva Investors, says in developed markets the choice is increasingly between buying companies that can grow or companies that can pay a dividend, while in emerging markets “one can invest in companies that are both growing and capable of paying dividends.”

Arun Sai, senior multi-asset strategist at Pictet Asset Management, says the picture is a bit more nuanced as he feels many of the companies that should be paying dividends are those which are commodity producers, and notes the “more tech focused” businesses would be better served by not paying dividends. 

But he says that in general “emerging markets are at different stages of development, and so should not be treated the same way.”

If the income case for emerging markets is closely linked to the commodity price, Charlie Bond, emerging market equity investor at Invesco, says commodity prices could be on a longer-term upward trend, as he notes “there has been a structural under-investment in many areas of the commodity market for many years, and so we are constructive on commodity prices as a result.”

For Ewan Thompson, manager of emerging markets and India funds at Liontrust, a “goldilocks” situation is possible for the asset class this year, and in that scenario, would be very positive for emerging market income stocks. 

The goldilocks scenario he envisages is “a mild recession in the US, which keeps the dollar relatively weak but isn’t damaging enough to hurt global growth, so emerging market assets grow.”

Emerging markets growth occurring at the same time as dollar weakness would increase the relative attractiveness of the income earned by emerging market businesses in their own currencies, as the income from dollar-denominated assets, and particularly from US government bonds, falls in relative value. 

Rates of change

In terms of how to get emerging markets income in the most efficient way right now, Kevin Thozet, a member of the investment committee at Carmignac, says: “One of the advantages emerging market economies have right now is that because they put interest rates up to combat inflation some time ago, if they need to stimulate economies due to a global downturn, they can do so.

"And the equities that benefit from lower interest rates in emerging markets are generally the same as those which benefit in developed markets. So for example, one would expect utility stocks to do well.” 

As corporate governance across emerging markets also improves, so do the prospects for healthy and reliable dividends.Omar Negyal, JP Morgan

Utility stocks typically perform well when interest rates are being cut because investors view the income from utility companies as being almost as safe as the income from bonds or cash. So if the income from bonds or cash falls, then the income from utilities increases in relative attractiveness. 

Another of the issues often cited by sceptics of the investment case for emerging markets is the level of corporate governance, specifically around the treatment of minority shareholders and the propensity for controlling family shareholders to pay dividends.

But Omar Negyal, who runs the global emerging markets income trust at JP Morgan, notes this is changing. 

He says: “Income opportunities in emerging markets continue to grow. As corporate governance across emerging markets also improves, so do the prospects for healthy and reliable dividends.

"For example, Mexico is home to several promising sectors and managements who have committed to paying dividends. From an economic standpoint, part of the attraction is due to its position as a major commodity beneficiary but also its positive economic recovery.”

David Thorpe is investment editor at FTAdviser