Follow the emerging stars

In the hunt for pockets of growth in the global economy, investors have tended to gravitate to the comfortable familiarity of megacap technology. However, that growth comes at a lofty price. Carefully selected emerging market companies may offer similar exposure at a fraction of the cost. As the dollar weakens, economic growth revives and central banks cut rates, emerging markets merit further examination. 

It is no secret that emerging markets have been widely unloved. Gavin Haynes, investment consultant at Fairview Investing, says: “Rising interest rates, inflation, a strong dollar, geopolitical tensions and a slowdown in China – which makes up about 30% of the MSCI EM Index – have contributed to high risk aversion and negative sentiment for emerging market equities.” 

While the sector has seen a better year in 2023 – the benchmark index is in positive territory and India and Brazil have both generated double digit returns – valuations are still cheap by historic levels. Carlos von Hardenberg, co-founder of Mobius Investment Trust, says: “We have never seen such a dramatic discount to the US market – it is the highest in 60 years. There is still a lot of scepticism and pessimism.”

Megatrends

Yet emerging markets are plugged into some of the strongest structural growth stories globally – from semiconductors to electric vehicles to digitisation. Von Hardenberg says emerging markets are leading in the energy transition, supplying the ideas for software, specialist materials or IT equipment. 

He adds: “Emerging markets are in pole position to benefit from these industrial changes. They are also strong in the Internet of Things. There are leading companies in Taiwan, Korea and Brazil.” Nevertheless, he identifies India as the hotspot. “There is so much investment there. Apple is putting tens of billions into India, benefiting from its business-friendly environment. This is generating stronger-than-expected economic growth.”
 

Haynes says other longer-term themes remain in place: “Structural themes such as consumption from the growing middle class and widened access to financial services and healthcare provide compelling opportunities. It is not all about China, with India ASEAN markets and Latin America offering diversified opportunities.” 

There are other, macroeconomic factors that could drive emerging markets from here. Chetan Sehgal, lead portfolio manager of TEMIT, says: “Rate cuts are on the horizon. Several emerging markets have already started rate cuts, which should be supportive for consumption.” Haynes adds: “Emerging markets bounced strongly in November on the widening belief that we have seen peak interest rates and we saw a weakening of the dollar. Also, most global asset allocators are underweight the sector.”

Upcoming elections

There are risks. There are upcoming national elections in 2024 in many key emerging markets including India, Indonesia and Mexico. Taiwan may also be a flashpoint for geopolitical tensions, with the China-unfriendly DPP party likely to be re-elected. However, Sehgal believes that far from being a risk, they may actually boost consumption, as incumbent governments may introduce expansionary fiscal policies to garner support.

China remains a significant part of emerging market indices and is a key variable. Many now consider it uninvestable, as a result of its lack of transparency, government interference and geopolitical tensions. The average China-focused investment company is down 14% in the 11 months to November. China may continue to weigh on emerging markets, especially for those invested in index tracker funds which have no choice but to maintain their exposure. 

A final consideration for investors should be whether to look deeper into emerging markets through, for example, a frontier markets fund. Trusts such as BlackRock Frontiers have performed well this year, providing exposure to interesting niche markets such as Indonesia, Saudi Arabia, the Philippines and Vietnam. These are also exposed to structural growth trends, such as electric vehicles, or the movement of manufacturing away from China. 

It is possible to find growth stories in emerging markets every bit as exciting as megacap technology, but at lower valuations. An active emerging markets strategy should be able to find these areas, while avoiding the pitfalls. There are risks, but the sector holds promise for the year ahead.