Emerging markets contain real opportunities for discerning investors

Article published in Le Temps, September 9, 2018

It can be hard, sometimes, to block out the noise and focus on what really matters. But, when it comes to emerging markets, this can be an incredibly useful skill for investors looking for attractive long-term opportunities.

In recent months we have heard and read a lot about different crises in developing countries. The macroeconomic crisis in Turkey, for example, continues to dominate the news agenda and has thrown a spotlight on the risks of investing in emerging market economies. We believe, however, that the majority of emerging market economies remain fundamentally strong.

Turkey has had a tumultuous few weeks. The Lira has collapsed as the diplomatic crisis between Turkey and the United States rolls on, and US sanctions have come at an especially bad time for the country as the central bank has repeatedly missed opportunities to address a credit-fuelled overheating of the economy. Venezuela and Argentina have also dominating headlines as both are grappling with economic problems of their own that have drawn considerable public attention.

However, we believe the problematic countries attracting the most attention do not, in fact, offer an accurate representation of emerging market economies as a whole. Investors who assume these troubled nations are reflective of emerging market economies as a whole risk overlooking what we believe are attractive long-term investment opportunities.

In our view, these developments are best viewed in isolation. While the MSCI Emerging Markets index has fallen 18% from its peak in January, the drivers behind this are limited to a small number of countries and sectors. The problematic countries are either extremely small components of the MSCI benchmark or are not included at all. Importantly, these declines  follow a strong year in 2017 when the index rose 37% in USD terms.

Over the past two decades, emerging market equities have structurally changed. Countries that previously dominated the index, such as Brazil, Mexico and South Africa, have been displaced by China, South Korea, Taiwan, and India. This has been accompanied by a structural shift in sectors too. Commodities, utilities and telecoms now make up a much smaller proportion of the index. Technology, which accounted for a little over 5% of the index in 1997, now makes up closer to 28%. This evolution has led to a profound financial shift with less capital intensity and more capital efficiency.
 

Looking to the US

Meanwhile, the dollar is strengthening, which is widely perceived as bad for economies with a lot of dollar-denominated debt denominated. However, the percentage of corporate debt issued in dollars by emerging market companies only accounts for 16% of the total. A significant amount of today’s dollar-denominated debt is issued by corporates whose revenues and costs are also denominated in dollars, which should lessen the impact of the strengthening dollar.

There is also the growing threat of a fully-fledged trade war between the US and China. However, we believe the effect of this on emerging markets broadly may be limited as most have strengthened their domestic economies in recent years. Imbalances between emerging markets and developed markets were previously far more pronounced. Emerging markets, and especially China, were huge exporters of goods at a time when developed markets, with the exception of Germany, were massive importers. These imbalances have been corrected over the past 10 years as Asia in particular has grown its domestic share of GDP.

That said, we are watching the situation between China and the US very carefully. If things were to deteriorate into an open trade war, we would expect that to have some negative impact across markets.
 

What does this mean for investors?

While emerging markets have been in decline since late January, this represents a relatively minor drop overall, in our view. History has taught us that this type of correction is not unusual in a bull market cycle. For instance, from 2003 to 2008, equities doubled relative to the MSCI World index during a US tightening cycle. There were, however, two short-lived corrections in 2004 and 2006 which amounted to a fall of 13% relative to the MSCI World.

The fundamentals of emerging market economies remain strong, which is reflected in the lack of earnings revisions witnessed since the start of 2018. The earnings dynamics in these economies are, in our view, on par with Europe. While market moves have been quite contained and modest in the context of the recent bull market, they should not be ignored from a valuation opportunity perspective; we believe the recent correction makes for an attractive entry point to emerging market equities.