Case for investing in emerging markets remains intact

18 Oct, 2018 by Dwarka Lakhan

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Emerging and frontier markets (EM) are the future of global investing. Compared to their developed market counterparts, they offer the opportunity to invest in a faster growing and more geographically diverse range of countries and sectors, providing scope for broader diversification and potentially greater risk adjusted long-term returns.

While EMs, of which frontier markets are a subset, currently comprise about 14% of the MSCI All Countries World Index market capitalization, they collectively include 59 different countries on the MSCI Emerging and Frontier Markets Index, compared to 24 developed markets (DMs) on the MSCI World Index.

Incidentally, the size of EMs vary widely, with the stocks of six markets – China, South Korea, Taiwan, India, Brazil and South Africa – currently accounting for more than 75% of the weight of the MSCI EM Index.

“EMs represent one asset class that will continue to grow; that will not go backwards,” contends Matthew Strauss, vice-president and portfolio manager with CI Investments Inc. in Toronto. He says that as the economies of EMs continue to deepen, accompanied by ongoing growth of their financial sector, an increasing number of investment opportunities will open up for investors.

One of the key drivers of EMs is their much faster economic growth, compared to DMs. According to IMF estimates, the GDP of EMs is expected to grow at double the pace of DMs in 2018: 4.9% for EMs versus 2.5% for DMs. The gap is expected to widen with estimated GDP growth of 5.1% in EMs versus 1.7% in DMs in 2020.

As a result of their higher growth rate, EMs currently account for 75% of global GDP growth, says Christine Tan, associate vice-president and portfolio manager with Sun Life Global Investments in Toronto.

Chetan Sehgal, Singapore-based senior managing director of Franklin Templeton Emerging Markets Equity, part of Franklin Templeton Investments  suggests that EMs are benefitting from several factors, including “a supportive global macro backdrop, improving economic fundamentals, ongoing reforms, a favorable earnings outlook and attractive valuations.”

EMs are also now “better managed than in the past” and the risk traditionally associated with investing in them has declined, says Arup Datta, senior vice president and head of Mackenzie Investments global quantitative equity team in Boston, Massachusetts – although they are still perceived as risky. But such risk is typically associated with higher long-term returns, he adds.

Sehgal says “the structural case for EMs continues to center around demographics, a rising middle class, domestic consumption, and the growing adoption of technology.” Many countries have also benefitted from “reformist business-friendly governments which seek “to reduce bureaucratic barriers to economic growth and encourage entrepreneurship,” he suggests.

Tan suggests that a rising middle class and a younger demographic have a “positive multiplier effect” on EM economies, characterized by “higher incomes, increased consumer spending, and the acceleration of infrastructure development.”

Concurrently, “EM companies have also undergone a significant transformation from the often plain-vanilla business models of the past, with a new generation of innovative companies that are moving into technology and higher value-added goods and services,” suggests Sehgal.

What is important to note is that EMs are not a homogenous asset class, says Tan. They are at different stages of development, “some are mature; some are early stage.” Adds Datta, “it’s a mistake to lump all emerging markets into a single asset class.”

India, for example, says Tan, has a younger population which has contributed to strong growth in consumption, whereas China has an aging population that has resulted in higher social spending in areas such as healthcare, education and travel. .

Strauss advises that when investing in EMs markets you have to consider the region, the country and the sector in the decision making process. For instance, he says Latin American EMs and South Africa are endowed with natural resources and are most vulnerable to a decline in commodity prices. However, while “lower oil prices, for example, are bad for producers, higher prices are bad for net importers such as Turkey and India,” he says.

On the other hand, countries such as India and China which are more reliant on exports can be affected by a global downturn and by issues such as trade protectionism which has reared its ugly head under the Donald Trump administration in the US.

But most EM “companies also now have a domestic component to their growth” and consequently are not as reliant on exports. Strauss advises that “commodities are (also) no longer a core theme when looking at EMs.”

In fact,  “emerging markets as an aggregate have been shifting towards ‘new economy’ industries underpinned by innovation and consumption” He contends that “many investors continue to view commodities as the dominant driver of emerging markets but we consider this a misperception” – even though “commodity production and export remain important to certain economies.”

A version of this article first appeared in Investment Executive

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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