Is now a good time for investors to increase their emerging markets (EM) exposure? Nick Payne, Head of Strategy, Global Emerging Markets, and Oliver Lee, Investment Director, discuss where they are currently finding the best investment opportunities, the countries and sectors they continue to avoid, and how they incorporate ESG factors into their fundamental research process.
As we entered 2022, many would never have imagined the tragic events that would unfold. Russia’s invasion of Ukraine has unsurprisingly rocked markets on a global scale, as Western leaders have moved to impose heavy economic sanctions on Russia. The MSCI Emerging Markets Index sold off sharply after the invasion, and while the index has since recovered some earlier losses, it remains down 5% since the start of the year1 .
While those markets closely linked to Russia or Ukraine have sold off the most, we have seen widespread falls across emerging markets (EM), regardless of fundamentals. The asset class as a whole is now looking particularly cheap to us, both relative to history and compared to other stock markets.
Given the breadth of the EM investment universe, and the fact that these countries can face more political, economic or structural challenges than developed countries, an active approach is especially important, in our view. It can allow us to mitigate some of the key risks associated with the asset class, while also accessing the great investment opportunities – or ‘super-compounders’ – available in less risky countries and sectors.
Incorporating ESG factors
As oil, gas and commodity prices have surged, energy and commodity exporters have performed particularly well year to date, while importers have generally suffered and remain under pressure. While this has been a relative detractor for the Global Emerging Markets Focus strategy, we tend to avoid holding commodities and oil companies in our portfolio for two main reasons.
Firstly, these companies are cyclicals, meaning they are price takers, and their profitability depends on the underlying prevailing commodity prices. We instead prefer to focus on quality, growth companies, which can be price makers, with more control over the destiny of their business.
Secondly, ESG (environmental, social & governance) has been a key component of our fundamental analysis for many years, predicated on our belief that company culture is extremely important for long-term and sustainable profitability. Our strategy promotes the transition to a low carbon economy, and we also expect investee companies to align with or be signatories to the UN global compact principles. This means we exclude all companies whose main business activity is linked to fossil fuels, as well as all military spending and tobacco. These exclusions differentiate us from the MSCI Emerging Markets Index: in fact, our strategy has 97% lower carbon emissions than the index.2
Russia: uninvestable for years
This is also one of the reasons why we’ve chosen to avoid investing in Russia for several years – it has always been a commodity-heavy market and largely correlated to the medium-term oil price. Furthermore, for some time we have been cognisant of the significant political and governance risks associated with investing in Russia, and we chose to exit our remaining position there following the Salisbury poisoning in 2018.
In the wake of the invasion of Ukraine, our strategy benefitted from not investing in Russia, both relative to the index and to our peers. This positioning was unusual in our wider peer group: as of the end of 2021, only 8% of emerging market funds didn’t hold any Russian positions3 , though Russia is now uninvestable, and has been removed from the MSCI Emerging Markets Index.
Elsewhere in the region, we continue to hold a position in Bank of Georgia. In February it sold off sharply due to unfounded contagion risk, though it has slightly rebounded since then. We think it’s a great quality bank, it delivers a 25% ROE (return on equity), and it has strong longer-term growth prospects. It is not a widely held position among EM managers, and it looks attractively priced to us.
India: a strong growth outlook
On a country level, India is our largest overweight allocation, at 22% compared to 13% in the index. We think it has a great long-term investment case, and its GDP (gross domestic product) growth outlook is very strong, with the government forecasting growth of 9.2% this fiscal year and between 8% and 8.5% next fiscal year. This accelerating growth story is reflected in rising company earnings forecasts, with India looking set to record the second highest earnings growth in Asia this year.
The ongoing conflict in Ukraine does not directly impact India, though we do note it could have an indirect effect in terms of higher inflation due to the increase in energy prices. However, India’s economy is far less sensitive to the oil price than it used to be, due to the growth of export industries over the past decade, which provide hard currency cash inflows to cover the cost of imported energy. Furthermore, India has held up relatively well in the face of the conflict, in part because its growing domestic investor base is supporting the market, making it less volatile than in the past. There is plenty of scope for this trend to continue, given the significant levels of savings by Indian households, but with only 5% directed into the stock market.
China: an improving backdrop
China was one of the most unloved equity markets in 2021, and it has continued to underperform year to date. While our underweight positioning was positive for our strategy last year, this year we have taken advantage of very cheap entry points by adding to holdings in Alibaba, Tencent, JNBY (clothing) and Country Garden Services (real estate property services).
We believe the backdrop in China is improving, and there are several reasons to be more positive. In terms of the most recent developments, we were encouraged to see Chinese policymakers reinforcing their commitment to achieving their 5.5% GDP growth target. This means that policies around regulation and zero-tolerance for Covid are starting to be relaxed somewhat, as policymakers move to prioritise economic growth. Monetary policy is becoming more accommodative, and we expect to see further fiscal stimulus, along with other supportive measures for consumers.
Focusing on super-compounders
While investors must remain aware of the risks that can come with EM investing, incorporating ESG factors into our fundamental research process has allowed us to successfully mitigate some of these risks. Emerging markets are home to some truly world-class companies, with the potential to deliver strong returns. These ‘super-compounders’ exhibit high profitability, have robust competitive advantages and the ability to reinvest back into their businesses to fund future growth.
We are not top-down thematic investors, but our investment process leads us to invest in companies that largely fall within four key themes: digitisation of businesses and consumers, consumption upgrade, technological plumbing and financial inclusion. The pandemic has fast-tracked some of these developments, such as e-commerce and online learning, and we expect these four areas to thrive over the coming years.
Four high-conviction themes
We see multi-year, structural growth opportunities in the following areas:
Digitisation of business/consumer Financial inclusion
E-commerce, cloud computing, social media, digital payments Access to financial products, fintech, digital payments
Technological plumbing Consumption upgrade
Microchips, datacentres, cloud infrastructure, 5G, AI Wealthier middle class, higher quality products, lifestyle improvements, demand for services
1 Source: Bloomberg, as of 25.03.22, in GBP
2Using the MSCI ESG Carbon Footprint Calculator, the strategy’s carbon emissions per $1m invested was 6.7 tons CO2e as of 04.01.2022. By comparison, the MSCI EM Index has 216.0 tons CO2e per $1m invested.
Quality can thrive through volatility
Has the outlook changed for emerging markets?
Emerging markets in 2022: headwinds to become tailwinds
Notes from the Investment Floor: What was achieved at COP26?
Resilience first in the post-Covid world
The value of active minds: independent thinking