International | Feb 09 2022
Emerging Markets equities look cheap in comparison with developed economies, but investment experts are opting for specific strategies and exposures to manage risk in 2022.
-Emerging Market equities look cheap
-Headwinds stem from rising interest rates and bond yields
-Risk profiles differ between countries and sectors
-Experts are focusing on stock picking and specific exposures
By Danielle Ecuyer
Diversification is often referred to as the key to risk management – ‘don’t pop all your eggs in the one basket’.
Then, most likely you will be asking yourself at some stage, should I invest in emerging markets and is 2022 the year to do so?
A brief overview of EM
Emerging markets (EM) is a broad term for many countries, stocks and varying degrees of economic growth and development, so, before investing into the latest Emerging Market product or ETF, you should do some homework into what you are potentially buying.
Emerging markets according to the MSCI Emerging Markets Index (USD) encompasses large and mid-capitalisation companies across 25 Emerging Markets (EM) or some 1420 stocks.
China represents around 32% (around 11% in 2006) of the index, followed by Taiwan (16%), South Korea (12.8%), India (12.5%) and Brazil (3.9%). Ten stocks represent almost 25% of the index.
As you can see some of the world’s largest and most important technology companies have a large weighting in the index, such as Taiwan Semiconductor and Samsung Electronics, with a skew to Info Tech, Consumer Discretionary. Northern Asia (China, Taiwan, and Korea) represents 60% of the total index and Asia in total 75% of the MSCI Index.
Taiwan Semiconductor is now around the ninth largest company globally by market capitalisation and investing heavily in new plants to expand its production capacity.
The emerging markets name belies the changes that have taken place, particularly in North Asia since the GFC. The standout growth has been in the Information Technology, Consumer Discretionary sectors at the expense of the Energy and Materials Sectors which have shrunk as a proportion of the MSCI Index.
Source: ANZ Bank Annual outlook “Emerging no more? The rise and rise of Emerging Markets”
Intuitively, this is hardly surprising given the rise of the Asian digital economy and the burgeoning middle-class consumer, particularly in countries like China, where the tech behemoths Alibaba and Tencent have become household names.
Most investing products, either active or passive, will work around the MSCI EM index as the benchmark. Thus, the first observation is that a ‘general’ recommendation of buying emerging markets means you are obtaining a large exposure to three countries and very specific sectors.
Martin Currie provides a reminder in their Global Emerging Markets 2022 outlook that “China will continue to be a key determinant of emerging market returns, given its prominence in the region”.
Emerging Markets Performance
ANZ Bank’s Global Annual Outlook cites that the relative valuation gap between emerging and developed markets is now at its highest margin in 20 years, both at a price-to-book (P/B) and price-earnings (P/E) level. Apart from some brief rallies, EM equities have underperformed developed markets by an average 4% per annum since 2009.
China’s performance was a notable drag on the index in 2021, with much of the gains from the pre-crisis recovery lost due to Xi’s ‘common prosperity’ strategy that deflated the property sector and clipped the wings of China’s billionaires with flow-on impacts to public markets.
Is 2022 the year for emerging markets?
ANZ Bank is increasing their allocated weighting to emerging markets in 2022. Martin Currie is also positive on emerging markets, with the attractive relative valuation to close as negative sentiment subsides with companies expected to deliver on earnings growth.
Martin Currie’s investing style is aligned with a strong ESG focus and picking quality companies with sustainable growth. The historical Martin Currie portfolio picks generated higher 5-year average revenue growth and higher 5-year average Return on Equity, while the MSCI EM ESG Leaders Index outperformed the MSCI EM Index by over 60% over the 10-year period ending Dec 2021.
From a sector perspective Martin Currie is attracted to two major themes, the financial sector including the technology/digital banks, Fintech as well as the traditional banks and insurance companies.
The other major theme is the ‘green energy transition’ with opportunities in renewable energy, battery storage and the like.
Federated Hermes is also positive on the decarbonisation theme and has chosen exposure to aluminium and copper through investments in Chile and Peru, despite what they perceive as shorter-term political risk.
Financials are another sector they like, as financial services (wealth management) and insurance (life and general) across most EM markets are relatively immature and therefore offer structural growth opportunities with growing middle classes.
Risks – inflation and rising interest rates?
Emerging markets are equally experiencing inflation rising from the lower pre-pandemic levels, meaning growth in earnings, stock picking in secular themes seem to be the choice in risk management for both Martin Currie and Federated Hermes.
The risk profile across emerging markets is not the same. Asia is relatively better positioned with lower inflation and higher levels of foreign exchange reserves for rising interest domestically and abroad. By contrast, countries in the EMEA (Europe, Middle East, and Africa) ex Russia and LATAM are more vulnerable, as they have lower FX reserves, higher inflation and a high proportion of short-term foreign debt.
For some of us the memories of the 1997 Asian currency crisis are a reminder of what can go wrong in emerging markets.
Geo-political risk is also very much on the radar for major investors. China, India, Brazil, and Korea all have varying types of leadership issues and elections. Then there is the overhang of will they won’t they invade for Russia into the Ukraine and China into Taiwan.
Reading between the lines, experts like the emerging market valuations, but remain wary of the geo-political risks and vulnerabilities to inflation spikes and higher interest rates.
Although valuations are compelling, stocks with exposure to secular themes with a quality, growth ESG slant seem to be preferred which means traditional index weighted products may not deliver the returns you desire for the risk you need to take.
Danielle Ecuyer has been involved in share investing in Australia and Internationally for over three decades, both professionally and personally and is the successful author of Shareplicity. A simple approach to investing and Shareplicity 2. A guide to investing in US stock markets.
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