While most developed markets have been able to take a breath as COVID-19 vaccination rollouts have been swift, this can’t be said for many emerging markets (EMs).
The pandemic has had a devastating impact on EM countries as they have some of the highest population densities in the world.
Investments in EMs have always been tricky as investors have needed patience and they will continue to need confidence as managers forecast a challenging year ahead.
However, flows into EM funds have picked up with inflows amounting to US$1.2 billion ($1.5 billion) globally in the first three weeks of May, according to Bank of America data.
Fidelity director and cross-asset investment specialist, Anthony Doyle, said in the year post the March 2020 global sell-off, the regions more heavily weighted towards technology such as China and Asia performed really well and had outperformed their developed market counterparts.
On the other hand, since the development and rollout of vaccines, the emerging market regions skewed towards basic materials, financials and commodities such as Latin America and EMEA generally had had a tailwind behind them.
“Whilst you have that strong rotation theme, it is undeniably still the case that these parts of the world in EMs, whether it is Brazil or Russia, are still dealing with this pandemic,” he said.
“When we look at how many vaccines these governments been able to obtain – whether actual or in terms of commitments – and subsequent rollouts they’re far behind say the US, UK and other developed markets.
“Subsequently you’ve seen a further wave in countries such as Brazil and India which has impacted on sentiment in those countries.”
Doyle also said while China was the only economy to expand in 2020, there was a shift in expectations that developed market growth would be superior to emerging markets over the next year given the strengthening US dollar.
“When the US dollar weakens, you’ll find EMs tend to outperform as US-based investors look to EMs for capital flows,” he said. “However, the US dollar has strengthened and in the short-term this will be a headwind for EM performance.”
Aberdeen Standard Investments (ASI) senior investment specialist, equities, Ben Sheehan, said the global economic growth recovery was good for EMs.
“We expect strong earnings momentum thanks to a combination of long-term structural growth forces and cyclical growth forces.
“We have a re-opening and reflation trade that has benefitted cyclical sectors in 2021 including energy, materials, financials, and industrials,” he said.
“In terms of structural growth drivers, we still have longer-term trends such as premium consumption growth, the role of EM-domiciled companies in tech supply chains, increasing levels of innovation in tech and healthcare, urbanisation, and the need for infrastructure. The broader backdrop for EMs moving forward will benefit from these cyclical and structural growth forces.”
Sheehan said some of the bigger trends in EMs were the rising living standards, demand for healthcare services and products, financial services, and technology. He noted that he had experienced a lot of support over the past year for EMs as investor allocations to EMs returned strongly after ‘soft data’ in 2020.
“Valuations in EMs are about 30% to 40% cheaper than the developed world on a price-to-earnings basis so there’s value to be found,” Sheehan said.
“On the earnings side, EMs are broadly expected to have a strong recovery in earnings this year. While earnings per share (EPS) growth for MSCI EM index dropped 15% in 2020, earnings expectations for 2021 are at 50% plus EPS growth.
“So, the earnings recovery and the visibility in earnings drivers I believe are bringing investors back to the market and clearly they are getting good value as well.”
Forecasting a pandemic
Despite the pandemic and the global sell-off, Northcape Capital Global Emerging Markets fund returned the highest against its peers at 32.8% during 2020, according to
The sector average was 5.75% and the Northcape fund beat the next best-performing fund by almost 40%. The fund was also the highest performer over the 10 years to 30 April, 2021, at 187.47%. The sector average during this period was 90.76%.
The fund’s director and portfolio manager/analyst, Patrick Russel, said one of the fund’s long-standing beliefs had always been that a pandemic would a big exogenous shock risk to capital markets. Therefore, it had maintained ‘healthy’ exposures to healthcare and personal protective equipment for many years.
“We’ve been investing in EMs since 2008 so we had more knowledge of pandemic risks because we’d seen them come to play in Africa and Asia from time to time. There were a lot of near misses and we were of the view that it was only a matter of time before there would be a really bad pandemic,” he said.
“We felt like the bullet was already in the chamber of the gun and, as a consequence of this risk management system, we had a structural overweight to PPE stocks. Not only that, we had strong knowledge on how a pandemic would impact an economy and capital markets so we were able to make tactical adjustments to our portfolio quite quickly which underpinned our performance last year.”
Russel said, when the pandemic hit, the fund further boosted its exposure to the PPE sector, and elevated its exposure to companies that would benefit from the shift to working from home which was mainly in North Asian tech firms.
TIPS FOR ADVISERS
Russel said a pitfall for any advisers looking to invest in emerging markets for clients was to invest in an exchange traded fund (ETF) as sovereign risk was quite significant and investors were unable to manage that though an ETF.
“You also end up investing in a lot of large mega caps in EMs and many of them are government controlled and those businesses are not necessarily run in a balanced way for shareholders. I’d encourage advisers to invest in active fund managers that address the asset class, are acutely active, and highly selective,” he said.
This sentiment was echoed by Doyle who said investors would not want to be in a passive fund as investors did not want to be buying “the losers and the winners” given the idiosyncratic risks of the EM universe.
Doyle said the biggest queries he received from advisers were issues regarding environmental, social and governance (ESG) factors along with geopolitical risks.
“The reason we forecast higher return in EMs is that there is that risk premium involved in investing in a part of the world where the institutional framework isn’t as strong as what you see in say developed markets,” he said.
“With that in mind you have to undertake proper due diligence whether it be on the ESG side and of course on the corporate fundamentals of a company where you are allocating capital. We acknowledge the risk and compensate for taking those risks which is why we are based on the ground within the regions meeting with company management and undertaking proper due diligence to avoid any likelihood of permanent capital destruction.
“When we are looking at governance, we’re looking at who the auditor is, is it the company’s chief executive’s cousin down the road? We’re looking at whether it is a reputable auditor.”
Doyle noted that there were over 4,000 available companies on the Shenzhen Stock Exchange but once governance was screened, this number fell to 500.
Russel said his strategy included weeding out areas at risk of capital loss and putting investors in front of best opportunities at company and sovereign level. Core to this was having unrivalled focus on ESG factors, which advisers needed to turn their attention to when looking for an EM fund.
“If you focus on companies with exemplary ESG everything else seems to performs really well. Companies with high levels of corporate governance run more tightly and have better risk management systems, they produce better quality products and services and customers are happier. Staff morale is high with low turnover and they tend to attract higher quality staff,” Russel said.
“The dropdown of that is better financial outcomes, better return on income, better growth, more innovation, and more focus on long-term strategic decision making which is beneficial for sustaining shareholder value creation.”
While his fund tended to focus on the governance side of ESG, Russel said if a firm had a high level of governance then it also tended to have high ‘E’ and ‘S’ scores.
“That’s getting the horse and cart around the right way. The genesis of good company is good corporate governance and if that is in place the preconditions are there for good E and S. If corporate governance is weak you’ll probably see weak scores in E and S as well,” he said.
Despite the challenging outlook over the next year, Doyle said, over the long-term, EMs would be an attractive entry point on a risk-adjusted basis once normality returned and the pandemic was under control.
“For Australians it’s a part of the world that would do a great job for you if you are trying to meet those long-term investment goals especially when cash is going backwards in inflation-adjusted terms today,” he said.
Looking over the next three to five years, Russel said there were powerful tailwinds such as growing population pools which led to the expansion of the household sector which is growing demand for EMs.
“There’s a lot of industries that are somewhat underpenetrated relative to advanced economies so you’ve got structural growth in a whole range of consumer technological, autos and so on. Those are the tailwinds the asset class offers that are not so existent in advanced economies, where you’ve got much higher levels of household debt, more mature populations, and you’ve got much higher penetration of consumer goods into the household expenditure,” he said.
“It’s about hiring a manager that seeks those opportunities and avoids some of the risks you get from the asset class such as capital flight risk to a particular country or corruption due to some issue associated with a breach of corporate governance. Those are some of the risks in the sector that you need to avoid and then you need someone with a keen eye on best opportunities to capture strong capital growth from those aspects.”