Emerging markets (EM) tend to be viewed as homogenous – what is bad for one must have dire implications for another – but this is simply not the case anymore, if it were ever the case at all. Historical, geographical and cultural differences have always existed, and the path of economic evolution has proved equally diverse. If we go back two decades, China was the world’s favourite outsourcing destination, while Korea and Taiwan were the premier manufacturing hubs of electronic components globally. As such, these economies, with their pronounced export bias, still suffer when trade dries up.
However, many other emerging economies have been moving up the “value-add” chain and edging away from economic models which rely on their cheaper labour costs in order to corner the global market in low value exports. As a by-product of this economic migration towards higher-end production, the middle class population is expanding rapidly and increasingly shifting the GDP bias in favour of domestic consumption.
Russia has thus far failed to move away from hydrocarbons but is attracting headlines for very different reasons. Geopolitically the country has become challenged, but this has not yet catalysed a systemic or critical credit hit. It is a sanctions-induced valuation compression that has also weakened the currency back to 2016 lows. The question therefore, is whether all the above challenges have now been materially enough discounted. On balance, we believe that, at least, a neutral exposure to Russia makes sense, but this is a ‘brave’ call as the timing centres around political / sentiment / liquidity factors versus fundamental support factors.
Russia’s travails aside, we believe that there are grounds for optimism over the likely trajectory of EM equities. Unlike the case in the US, valuations are not stretched and, given years of progress in terms of corporate governance and economic stability, the EM universe is effectively the only remaining investment grade laggard. As such, we maintain our positive stance, despite the recent surge in protectionist posturing and rhetoric. It is important to remember that global liquidity continues to be high in absolute terms, despite the Fed’s attempts to both normalise interest rates and trim its bloated balance sheet.
Although we are mindful of the risks of protectionism, stronger domestic demand should help mitigate this. Furthermore, we firmly believe that medium-to-long term investors in EM equities need to ensure that they are on the right side of local structural reform programmes. For example, Saudi Arabia, which is seeking inclusion in the MSCI Emerging Markets index, is looking to diversify from the commodities trade through a focus on high technology – and this is just one example of a potentially ground-breaking shift. In China, we see three or four excellent trading opportunities in companies that are at the forefront of the country’s environmental reforms. Similarly, Mexico recently enjoyed a Moody’s Upgrade on its outlook from negative to positive. This is another example of an opportunity to buy quality companies cheaply to their history in an improving credit environment.
Aligning the composition of a portfolio to large-scale government reform programmes provides clearer earnings visibility and an enhanced risk / return profile.