Coming in from the cold
Renewed interest comes after wild performance for emerging markets through much of last year, hit by the surge in global inflation and the almighty US dollar.
Investors became more cautious about the index’s largest weight – China – as President Xi Jinping stacked his leadership ranks with loyalists, resulting in an exodus of Western capital from Hong Kong. The Hang Seng Index fell 40 per cent last year to a low of 14,597 in October.
But some sensed opportunity amid rumours China would relax its restrictive COVID-19 policies and prop up its beleaguered property sector, leading to a dramatic 50 per cent rebound between November and January.
“We’re now just starting to see China open up,” says Garry Laurence, founder of Profeta Investment Management and a former Perpetual stockpicker.
“It benefits China immediately in terms of its GDP growth, but then also has spillover effects into South-East Asia.”
The International Monetary Fund projects emerging market and developing economies to grow at 4 per cent in 2023. China is forecast to grow 5.2 per cent. Meanwhile, advanced economies will grow at just 1.2 per cent, and the UK is set to shrink by 0.6 per cent.
At the heart of the bullish outlook for emerging markets is a divergence in monetary policy from developed markets.
As Capital Economics chief economist Neil Shearing explains, while advanced economy central bankers spent 2021 debating whether inflation was “transitory” or not, their emerging market peers in parts of Europe and Latin America “got on with the business of raising rates to tamp down price pressures”.
“As these central bankers led the charge to bring down inflation, so they’re likely to be in the vanguard when it comes to cutting interest rates later this year,” he says.
Brazil is a key example, lifting the benchmark Selic rate in March 2021. Policymakers embarked on an aggressive campaign of interest rate rises, pausing in September at 13.75 per cent after 12 straight increases.
“Generally, EMs are being more front-footed than developed markets who have been very complacent about their fiscal and monetary policy,” Kersmanc says.
“These are countries that are very adept at dealing with inflation, having had massive bouts in the past.”
Northcape’s Cameron says this divergence is the “single most important factor” for emerging markets, far above any demographic theme yet to play out.
“The developed world is now moving away from unorthodox monetary policy, with the possible exception of Japan, because of the inflation problem,” he says.
“Meanwhile, EMs are keeping rates flat to cutting them, so that tailwind for DM equities that caused the performance differential is declining.”
China splits opinions
“Emerging markets” is a vast universe, capturing a diverse set of 24 economies from South Korea to Turkey. As such, managers tend to be highly selective about where they invest, and no country is more hotly debated now than China.
Cameron sits in the “avoid” camp, warning that strong GDP growth doesn’t necessarily equate to strong equities growth.
The Northcape EM fund has a small exposure to China (via Hong Kong), compared to the index, preferencing India, South Korea, Taiwan and Mexico. That’s not to say the manager doesn’t buy into the China growth story, but he prefers to gain exposure to the Chinese consumer via non-Chinese companies, particularly South Korean.
“For the last 20 years, China has been the greatest economic success story in history, and over that time, it’s been a lousy equity market,” he says.
“We remain cautious about the so-called ‘reopening’ because Chinese companies are not run exclusively for shareholders. Every company, regardless of what it says on the box, is a state-owned enterprise.
“What it means is when these companies make capital allocation decisions, it’s not just driven by growing shareholder value, it’s also driven by other goals. That dilutes the return on investment.
“What people are getting wrong about China is they’re seeing this reopening and mistaking that for a fundamental change, which it’s not. Common prosperity absolutely remains.”
Cameron’s EM preference is India, saying modest levels of GDP per capita mean the country still has growth ahead of it. He adds that Indian companies tend to be “sophisticated, well run, good allocators of capital, but there are exceptions”, making an obvious nod to troubles at energy giant Adani.
Key holdings include HDFC Bank, India’s leading private sector bank, and auto manufacturer Maruti Suzuki.
The GQG Emerging Market Equity fund is similarly underweight China.
“I agree from an economic standpoint, removal of zero-COVID will be very beneficial, but we are single-digit exposure in the EM fund,” Kersmanc says.
“A lot of the multiples are fairly frothy for the large liquid names, especially in the tech space, plus I can get the exposure, from an economic standpoint, outside of China without taking on that geopolitical risk.”
Energy and materials form a big part of GQG’s “China-but-not-China” play, with overweight positions in both sectors.
“Where we see risks to a Chinese reopening are energy. If the second-largest economy in the world with a billion and a half people starts moving around, we’re seeing on the ground data really starting to accelerate, that’s going to put upward pressure on energy, even if the US or Europe goes into recession,” Kersmanc says.
For a global portfolio that’s well diversified, having 20 to 30 per cent in China or EM is not an outsized risk, in our view.
— Brian Arcese, Foord Asset Management
Others are placing direct bets on China recovery and growth. Profeta’s Laurence says his fund’s exposure to emerging markets – especially China – is the highest it’s been in the past decade.
He is urging investors to diversify beyond the developed markets that served them well.
“We’ve got a situation where valuations in the US are high, sitting at around 18 times earnings, but earnings are decelerating and GDP is coming down with high interest rates,” he says.
“On the flip side, we’ve got countries like China where rates are still low, GDP is accelerating and valuations are pretty attractive.”
Laurence went on a China buying spree after the sharp sell-off, picking up names such as search engine giant Baidu.
The fund now has about 20 per cent in Asia, 10 per cent of it in Hong Kong-listed companies.
Other key holdings include the Taiwan Semiconductor Manufacturing Company, a leading semiconductor chip manufacturer, and Philippines-based Bloomberry Resorts.
“I don’t expect returns to be as good in the next six months as they were in the past six months, but I still see a lot of upside over the next few years, whereas when I look at the US, I just can’t see valuation upside with rates at 4.5 per cent and rising,” Laurence says.
Foord Asset Management portfolio manager Brian Arcese is similarly bullish on China equities, materially increasing his global fund’s exposure as valuations slumped.
Thirty per cent of the fund is now in emerging market Asia, with overweight positions in Chinese platform technology firms such as Tencent and Alibaba Group. E-commerce giant JD.com is also a top pick.
“What you’re getting in EM, but China in particular, is valuations that are 50 to 60 per cent less expensive [than the US] but with earnings growth,” he says.
“We wouldn’t suggest you put 100 per cent of your portfolio in China, but for a global portfolio that’s well diversified, having 20 to 30 per cent in China or EM is not an outsized risk, in our view.”
Arcese pushed back on suggestions China is “uninvestable”, saying Western investor fears are overblown.
“China is a small percentage of the global benchmark – around 2 or 3 per cent – so if you’re a global portfolio manager, you can more or less choose to ignore it,” he says.
“Even if it performs exceptionally well, it really won’t torpedo your investment performance, so it’s quite easy to label it as ‘uninvestable’.
“Common prosperity is a key pillar of the Chinese Communist Party, but the other important pillar is growth, you still need to continue to improve the lives of the Chinese people. It’s a balance.”
Sustained recovery?
The question lingering for EM is whether investors will continue to buy into the growth story, or flows merely return to the levels they were before the downturn.
Data provider EPFR Global has already noted waning interest in early February as more questions about the ceiling for US and European short-term interest rates, concerns about Indian markets and renewed Sino-US tensions threaten to spoil the party.
“The shooting down of a Chinese high-altitude balloon in US airspace reminded investors that relations between the US and China remain tense and that economic policy in both countries is currently focused on reducing dependence on the other,” director of research Cameron Brandt says.
So far, Australian investors are holding back, shaken by geopolitical concerns and a decade of underperformance, despite hopes the asset class would drive global growth and returns.
Russia’s sharemarket crash and eventual removal from the MSCI EM Index similarly shook confidence and reminded investors of the volatility that goes hand in hand with EM.
“China’s end to zero-COVID policy did not spark new buying of China funds by the end of the year,” funds network Calastone says, noting that Australian EM funds were in net outflows in Q4.
“Australians have been net sellers of China funds in 38 of the last 41 months.”
Super funds are also showing home bias, and less than 10 per cent of international listed portfolios are invested in emerging markets, NAB data shows.
While Arcese believes being underweight EM presents a greater risk to investors, he understands why some may be tentative.
“You need to have a diversified portfolio – there are risks everywhere, but the speed at which risk events happen is much higher in EM,” he says.
“There are plenty of developed market companies that over weeks, months or even years, go to zero, but in EM it can happen overnight.
“You do the best you can, you do your due diligence and, hopefully, you don’t own any of those companies, but in investing in those markets, you always have to be aware it can happen and ensure you don’t have outsized exposures.”