EM equities are currently experiencing one of their biggest ever corrections amid a perfect storm of tighter monetary policy, slowing global growth and crippling risk aversion. Investors may understandably be considering throwing in the towel. However, we firmly believe that the darkest hour is before the dawn, and that far from selling their holdings, investors should be increasing their allocations. Here are five reasons why.
1. Recovery potential.
Source: TT International
As can be seen from the graphic above, it has been an intensely challenging period for EM equities as investors moved to discount tighter monetary policy and a potential global recession. However, one of the ways in which EMs now stand out compared to their DM counterparts is the lower inflationary pressures that many are experiencing and the more timely policy responses from their central banks. It goes without saying that EMs are not a homogenous block; each economy is facing a different inflationary backdrop and monetary policy response. Some EMs such as Brazil and India currently have high inflation. Crucially however, their central banks have been raising rates for some time, in stark contrast to those in the developed world. This means that the extreme negative real rates that are prevalent across many DMs are simply not being seen in those EMs with high inflation. Meanwhile, in other EMs such as China, inflation is still very benign and expected to remain so, providing scope for liquidity easing. The benefit of all this could be rates peaking earlier in EM, or in currency strength for the asset class once risk aversion and the associated dollar strength abates. With many EM businesses now trading at trough multiples, we believe there is significant recovery potential once the market narrative shifts to focus on the rate cuts that central banks will inevitably have to implement to boost flagging economies. Whilst rate cuts are unlikely to take place in the developed world before the second half of 2023, markets will look to price in such moves far in advance. Of course, timing the precise bottom of the market is notoriously difficult to do. Our team has well over 100 years of EM investing experience and could still not accurately predict this. However, what we can say with a high degree of conviction is that for investors with anything other than a very short-term horizon, EM equities represent a significant buying opportunity at these levels. This view is supported by the data. As the graphic above shows, the average 12-month return following major EM corrections is extremely attractive.
2. Leading-edge technologies.
Whereas EMs used to rely on DMs for many of their most advanced technologies, they are now genuinely in the vanguard of the most exciting global investment themes, from semiconductors to the green transition. Whilst our portfolios have significant exposure to both of these themes, we were particularly early to identify and exploit the latter. Many of the world’s most cutting-edge and vital environmental technologies are being developed in Emerging Markets. For example, the vast majority of battery cell production, as well as the battery component supply chain, is dominated by Korea and China. The latter is not only leading in the renewables build out, but also completely dominates the global solar value chain. Taiwan meanwhile, by virtue of its leading expertise in the semiconductor and electronics industries, is a key beneficiary of the electrification of the planet. Not only are some of the most exciting environmental technologies being developed in Emerging Markets, but also many of the world’s most valuable renewable energy resources are located in the global south. Whether it’s onshore wind in Brazil that blows as fast as offshore wind in the northern hemisphere, or first-class solar resources in India and South Africa, Emerging Markets have a huge abundance of natural resources to equip them for the energy transition. We continue to believe that the long-term investment opportunities for environmental tech stocks are not just intact but have actually been enhanced over the last 6 months. Russia’s invasion of Ukraine has added impetus to the green transition, not only because fossil fuels are now far more expensive, but also because the push for energy independence has climbed straight to the top of the foreign policy agenda. The implications of this are profoundly positive for many EM green tech stocks. To draw on just one recent example, the landmark US Inflation Reduction Act will pump a record $369bn into clean energy, accelerating EV adoption in the US market, which has materially lagged Europe and Asia in this regard. The EV battery plays that we own should be key beneficiaries of this.
3. Engine of global growth.
Many investors ultimately buy Emerging Markets for the growth they offer. The IMF expects advanced and emerging economies to grow this year by 2.5% and 3.6%, respectively. However, in 2023 this growth differential is forecast to widen, with advanced economies slowing to an anaemic 1.4%, and EM economies accelerating to 3.9%. This gulf in growth should help to support the outperformance of EM over DM, particularly as it may prove to be even wider than expected as the developed world battles an intensifying cost of living crisis and attempts to absorb higher rates, which EM economies have already largely achieved. Ultimately in a world of stagflation, investors should pay more for growth, particularly for companies in countries with strong domestic drivers that are less dependent on the global economy. One example would be India, where favourable demographics and a flourishing rural economy should underpin strong structural growth. India’s property cycle has picked up after a long lull, credit growth is accelerating, and it appears to be on the cusp of a new private-sector capex cycle. We retain significant exposure to the country’s private-sector banks, which should be key beneficiaries of these trends.
4. Underappreciated value.
As can be seen from the first three charts below, EM equities are trading significantly below their median valuation over the past 20 years on both price-to-earnings and price-to-book ratios, whilst their substantial discount to DM equities has widened further in recent months. Their earnings yield is also far more attractive than cash or bonds. Thus, valuations appear anomalously cheap from both an absolute and relative perspective. Such value seems to be materially underappreciated as investor positioning in EM equities is light. Indeed, as can be seen from the final chart below, assets in EM relative to DM are near their lows, despite a shift in the inflation regime that should set EM up for a multi-year period of outperformance. All this should provide a degree of downside protection through the current market volatility, and further upside potential once sentiment turns.
Absolute Emerging Markets valuations
Source: TT International
Relative valuations versus Developed Markets
Source: TT International
EM earnings yield far more attractive than cash and bonds
Source: TT International
EM (%) share in Global AUM
Source: JP Morgan
5. Tailwinds blow across the asset class, from Growth to Value.
Whilst EM equities used to be heavily weighted to energy and materials companies, the index composition has changed markedly over the past 20 years and now has far more exposure to businesses with structurally higher returns in areas such as ecommerce and software development. These companies and their relatively visible earnings streams should command higher multiples, making the previous valuation argument even more compelling, particularly as we believe that the regulatory backdrop is now improving for China’s internet giants. Indeed, we have seen their share buybacks accelerate, and what finally appears to be the start of the process to bring Ant Financial to the market with its long-awaited IPO. We have also seen the government permit mainland Chinese investors to buy the HK Technology ETF, bringing access to companies like Alibaba for the very first time. At the same time, EMs still retain significant exposure to Value. For example, many companies in LatAm and MENA are key beneficiaries of higher commodity prices. While most commodities have fallen back from extremely elevated levels, we expect some prices to remain structurally higher due to the green transition. For example, because of their use in green tech, demand for commodities like copper and nickel should remain firm. Meanwhile on the supply side, ESG-related pressure on oil companies is persuading them not to invest in new capacity at a time when demand for oil remains high.
After a bruising sell-off it would be natural for investors to question their exposure to EM equities. However, for the reasons cited above and many others, we firmly believe that recent weakness is a buying opportunity for investors with anything other than a very short-term horizon.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).