The emerging markets “perfect storm”

Carlos Hardenberg, lead portfolio manager, Templeton Emerging Markets Investment Trust.

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Emerging markets are coming out of a “perfect storm” experienced over the last few years. After a gloomy start to the year, emerging market equities have entered an upward trend in 2016 and have received strong fund flows in recent months, as investors search for higher returns than those available in other asset classes. This has led emerging markets to outperform developed markets.

We have seen a number of factors combine to make emerging markets an attractive asset class for investors to consider now and for the future. The US dollar has stabilised, and this has largely benefitted emerging markets as it reduces the threat of a US dollar-denominated debt crisis. Many companies in emerging markets have issued debt in US dollars, making it harder to pay if the US dollar strengthens. Many emerging market countries are also making meaningful progress in structural reforms to stimulate growth and earnings. Moreover, there have also been signs of stability after a slowdown in the rate of growth of China’s economy.

Whilst attention has been on a turnaround in sentiment over recent months, it is important to emphasise that we invest for the long term. As well as looking at the current situation, we focus in particular on how we expect a company to develop over the next five years or more, and what that indicates for value in the current share price. This means that as “value investors” we can, and do, invest for example in fast growing technology companies where we see a disconnect between current market value and potential.

Emerging economies in general are some of the world’s most vibrant and fastest-growing economies. However, we believe the challenges faced by some countries, sectors and companies — such as commodity or utility firms and the Chinese financial or real estate sectors — have at times obscured for investors the many interesting opportunities within the emerging market space.

For example, we believe that mid-sized and smaller companies within emerging markets offer strong growth potential at attractive valuations. We also view this area as one that is overlooked by most investors — in part due to misconceptions regarding volatility, liquidity and scale. Further, there are several key positive attributes of emerging market small/mid-caps, both structural and tactical, which in aggregate we think support the inclusion of the asset class in our investment portfolios.

In the coming decades, successful emerging market enterprises and even countries are likely to be mostly those that secure pole position in the global race towards higher and more advanced technology development and adoption. A lot of groundbreaking new innovations in “bricks and mortar” industries such as retail, finance, and manufacturing are causing a tectonic shift in the global economy and, for the first time, companies based in emerging markets such as China, Taiwan, Korea and others are among the leaders. For instance, we have already observed that some of the most sophisticated components for advanced and ultra-light weight vehicles are made by emerging market firms. Modern power sources are being developed in emerging markets, branchless banking is being rolled out and e-commerce or online learning are widely adapted by emerging market consumers. We see opportunities both in some of the largest players such as Samsung and TSMC as well as specialist, smaller niche players with world leading technology.

In terms of markets, we are particularly interested in China at the moment following improving sentiment in the region. We are focused on the internet and technology sectors as we have found that many companies can enjoy strong structural growth as the economy shifts toward more online transactions, shopping and services. We also like some consumer-oriented companies, especially in the automobile sector and in sportswear. We look for opportunities in specific industries, largely those that are geared towards increasing consumption, that have gone through a consolidation, and industries where the barriers to entry have increased and the competitive environment has become more benign.

While the year is not yet over, we believe the emerging markets recovery is set to continue over the next few years. We see brighter prospects for investors in emerging markets, and the long-term performance of emerging-market equities continues to compare favourably to that of developed markets. While emerging markets remain sensitive to macroeconomic events and global monetary policy, equity markets appear to have begun to readjust, and we believe that investor confidence is returning.

Moreover, despite the recent increase in fund flows, investors remain considerably underweight in emerging markets, which we believe is supportive of a further re-rating over the longer term.