There is more to emerging markets than China
Markets are trying to get to grips with the long term effects of COVID-19 on the global economy, but the prognosis is hard to call. That has led to some volatility this year, which may be a feature of markets for a while yet writes James Carthew, Head of Investment Trusts
Simplistically, the markets that did best in 2020 were those where the virus was well-managed. That included countries such as China, South Korea and Taiwan. Indeed, JPMorgan China Growth & Income and Weiss Korea Opportunities were amongst the best-performing of all investment companies.
In 2020, investors also favoured growth stories, especially companies in the technology sector. That was good news for specialists such as Polar Capital Technology and Allianz Technology but also for generalist funds with significant technology exposure such as Scottish Mortgage and its stablemate Pacific Horizon (which had a double whammy by also being heavily exposed to those top-performing countries in Asia).
In summary then, 2020 was all about avoiding the worst of the pandemic and buying stocks that COVID-19 either did not affect or were actually boosted by lockdowns.
‘the markets that did best in 2020 were those where the virus was well-managed’
Towards the end of the year, however, the story started to change. In November, the good news on vaccines gave hope that we could get back to normal. This triggered a big rotation into ‘value’-style stocks, to the benefit of funds such as Temple Bar in the UK.
In 2021, investors are sizing up the potential long-term effects of the vast stimulus that has been injected by governments and central banks. Commentators are talking about the prospect of a global synchronised recovery this year.
China has just reported some spectacular GDP growth figures for the first three months of 2021 (18.3% year on year growth). The figure is distorted by the contraction of that economy in the first quarter of 2020. Nevertheless, China is re-expanding. At the same time, Joe Biden’s economic bail out holds out the prospect of a boom in the US.
Strong economic growth in these two powerhouse economies should more than offset any lingering gloom in Europe. However, the true beneficiaries of this may be emerging and frontier markets. One reason is that, even in the countries that were hard hit by COVID, the effect on their government finances was not as severe as it has been in the developed world. They should benefit from increased global demand without being so exposed to the worries about how this is all going to be paid for.
The US dollar has been weakening. Generally, when the dollar goes down, emerging markets go up. The reasons for this aren’t entirely clear – the effect on commodity prices perhaps, or a fall in the cost of servicing dollar debt.
‘the true beneficiaries of this may be emerging and frontier markets’
One idea is that, freed from worrying about their exchange rates, emerging market governments can go for faster growth. Another, is that a weak dollar is actually caused in part by investors looking elsewhere for riskier but more rewarding investment opportunities. Regardless, the two are related and this relationship has been working again over the last few months.
There are all the usual factors working in emerging markets’ favour too, such as younger populations and a growing middle class. There are even tentative signs that the emerging world is embracing the need for tackling climate change. For example, China is targeting net zero emissions by 2060. This creates opportunities for a whole raft of new companies.
The MSCI Emerging Markets Index is dominated by China (mainland China represented 37.9% of the MSCI Emerging Markets Index at the end of March 2021) and some investors have been using China as a proxy for all emerging markets, but this is overly simplistic. In fact, China has not been a great investment so far in 2021.
The Chinese government seems concerned that its economy will overheat and so it has been clamping down on lending once again. It has also been reining in the influence of some of its largest companies, such as Tencent and Alibaba, by targeting them with antitrust investigations.
However, there is far more to emerging markets than China. Countries such as Vietnam are seeing soaring growth as manufacturers switch production to this lower cost country from China. Commodity exporters such as Chile and South Africa have benefited as metal prices rise.
A strong recovery in the oil price is boosting the Gulf states and Russia. India has been seeing signs of life again, too, although a new wave of COVID cases is knocking confidence somewhat.
It is important to remember that emerging markets are not just plays on commodities and manufacturing exports. Most of the companies that managers of emerging markets funds are buying are in sectors such as technology, financials and consumer services. It helps that emerging market stocks are cheaper on average than their developed market counterparts, despite offering the potential for faster earnings growth.
‘companies that managers of emerging markets funds are buying are in sectors such as technology, financials and consumer services’
For example, the managers of Polar Capital Global Financials have been increasing that fund’s exposure to emerging market banks. They seek to profit from the growth that these companies can achieve as more of the population gains access to a bank account and consumers buy more sophisticated financial products for the first time.
Not all emerging markets are benefiting from investors’ attention. For example, Brazil is still hampered by its government’s inept response to the pandemic and the problem has spilled over into Colombia. In Turkey, President Erdogan’s ham-fisted attempts to control inflation and interest rates have backfired.
Navigating the myriad political and economic maze within the emerging market sector is probably a job best left to the experts. The big management houses have the depth of resource to do the job. There are ten truly global emerging market investment companies, one of which (BlackRock Frontiers) specialises in frontier markets that the index providers do not judge to be liquid enough or offer the same investor protections as emerging markets.
The best performing emerging markets investment company over the past year has been Aberdeen Emerging Markets. This is differentiated from its peers by investing through a mixture of open and closed-end funds rather than directly into stocks. Its managers, Andrew Lister and Bernard Moody, aim to make money from picking managers that will outperform, allocating money to the best-performing markets and buying shares in other investment companies on a discount and benefitting as those discounts narrow.
One of the Aberdeen fund’s standout winners in recent times has been its stake in Weiss Korea Opportunity. The team also predicted correctly that China would be one of the best places to be invested last year.
‘By 2025, 80% of the world’s growth could be coming from emerging markets’
However, today, Andrew and Bernard think that tensions between China and the US that began under Trump may not be resolved under Biden. The team has been taking some profits on Chinese funds and reinvesting in areas it thinks are cheap, such as Russia.
The Aberdeen Emerging fund has also taken meaningful exposure to frontier markets, an area that has been problematic in recent years, but which the team thinks could recover sharply if investors’ money starts to flow back into these countries.
Another fund with sizeable exposure to this area (up to a quarter of the portfolio) is Jupiter Emerging & Frontier Income. Its manager, Ross Teverson, was cautious on China last year on valuation grounds, and this held back returns. He thinks that 2021 will see a broadening of interest in the sector to other countries. He thinks that the structural growth opportunities in these markets are even greater than in China and this is not priced in. Ross highlights lower levels of debt in many of these countries, more favourable demographics and often better corporate governance.
Both sets of managers are more positive on the outlook for India than they were. Ross attributes some of this to the reforms that the Modi government has introduced to make its economy more efficient. Dedicated Indian funds with exposure to mid and small cap stocks, such as India Capital Growth and Ashoka India Equity have been doing much better recently (India Capital Growth’s NAV is up by 65% over the past 12 months).
Longer term, the best-performing global emerging markets trust has been JPMorgan Emerging Markets. JPMorgan Emerging has been managed for the past 27 years by Austin Forey, who focuses on buying and holding growth companies for the long term. Over the past few months, favouring growth stocks has held back the trust’s relative performance.
The sector’s largest fund, Templeton Emerging Markets has been similarly affected. Effectively, it has half its portfolio invested in just five companies – Taiwan Semiconductor, Samsung Electronics, the Korean web company, NAVER, and the two Chinese technology giants Tencent and Alibaba. Its NAV has been held back as these stocks have been hit by profit-taking. It seems a waste of an opportunity to us to put so much of your emerging market investments into so small a basket.
A recent quote from Andrew Lister sums up the opportunity: “Today, we see a much smaller contraction in emerging economies’ GDP and, looking into 2021 and beyond, economists are forecasting more rapid growth for these countries. Non-China emerging markets should account for almost half of global growth within five years. By 2025, 80% of the world’s growth could be coming from emerging market .”
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