Times are changing for emerging economies, according to Kunjal Gala. The Lead Portfolio Manager, Emerging Markets, explains why emerging economies are well-placed compared to developed economies in the world post major economic and geopolitical shifts. He also shines a light on the Federated Hermes Global Emerging Markets Equity Fund and explains its relative strengths.
Why does the Federated Hermes Global Emerging Markets Equity Fund make sense?
We’re taking a longer view and are looking for quality companies with pricing power and an ability to compound value sustainably over an extended period. We focus on regions and sectors that can deliver high growth relative to the rest of the world and megatrends that benefit from structural drivers and can help mitigate slowdown concerns.
We have analysed the events over the past two years (Covid, supply chain dislocations, energy shortages, geopolitical events) and focused on the medium/long term implications as we believe there will be lasting impact from these developments. The portfolio has undergone a significant refresh over the past two years reflecting these developments and remains relevant for the future.
Cyclically, emerging markets continue to trade at a 30-40% discount to the developed world – which implies negative sentiment and muted investor interest. Our fund is trading at a very attractive level and offers better growth and return on equity profile versus the benchmark.
What themes underpin the fund’s strategy and how do you expect them to deliver over the next three to five years?
The fund has exposure to a range of structurally attractive themes that are benefiting from secular drivers.
We believe exposure to these opportunities will mitigate the impact of any macro slowdown, volatile input costs, the rising cost of capital and costs associated with addressing climate-related issues in the future.
How has the positioning of the fund changed over the past year?
Regionally, we moved to overweight Latin America. Broadly speaking, the commodity cycle needs to turn for Latin America to meaningfully outperform the rest of the world over a reasonable period. You also have to keep in mind that commodity cycles tend to take 10 to 15 years to play out in Latin America. But as we are roughly 10 years from the previous peak and certain resource sectors appear to be substantially undersupplied, the odds favour a period of sustained outperformance for the region in the coming decade.
How are you future-proofing the fund against climate change risk? How is it contributing to net-zero goals?
We select companies with attractive business models and seek to improve material ESG issues through engagement. We also maintain a low carbon footprint and prioritise engagements with any holdings in the extractive industries or those with higher levels of emissions.
Our fund is considerably greener than the MSCI emerging market benchmark in terms of Scope 1, Scope 2 and Scope 3 greenhouse gas (GHG) emissions and exposed to companies providing critical renewable technologies, so it’s well positioned to benefit from the sustainable energy transition. In addition, the fund also seeks to mitigate any unfavourable headwinds that resource heavy cyclical businesses are likely to suffer in the years to come due to expensive transition or need to fund new businesses.
What do you expect in the medium to long term?
In the medium and long term, we anticipate a shift in the investment environment that will likely be decisively different to the past ten years. We expect a regime change as investors evaluate the impact of higher-than-normal inflation and cost of capital with sticky supply-side constraints. That shift will create winners and losers.
It also means, however, that emerging markets have a golden opportunity to improve their competitiveness. Concretely, they can capitalise on their leadership in growth and demographics as well as their manufacturing prowess and resource availability.
We expect several emerging economies to benefit substantially from a relocation in supply chains, which has already begun. All that is happening while the developed world is still learning to adjust to high inflation and structural challenges investors are only starting to consider now.
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Kunjal Gala
Lead Portfolio Manager, Emerging Markets, Federated Hermes Limited
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Supported by reforms, emerging economies have the right ingredients to succeed long term, says Federated Hermes’ Kunjal Gala
In the medium and long term, we anticipate a shift in the investment environment that will likely be decisively different to the past ten years.
How do you expect the growth differential between developed and emerging economies to evolve?
Over the past few years, the growth differential between emerging and developed economies has narrowed. However, growth in emerging economies is likely to outperform the developed economies sustainably over the medium/long term – and there are several reasons underlying this expectation.
First, consumers and businesses in the emerging world have adjusted to moderate and high inflation in the past. That is unlike their developed world counterparts, who are experiencing inflation at levels they haven’t seen in a long time. Higher inflation has led to a shift away from ultra-loose monetary policies that will put brakes on credit-led growth in advanced economies.
Second, many emerging economies are well-placed to navigate the sticky supply-side constraints that the developed economies are finding difficult to manage (shortage of critical resources, energy, workforce). Crucially, better supply of workforce is helping sustain industrialisation in several emerging economies.
And third, the vast majority of developed economies will find it increasingly difficult to invest for growth in their economies. They’ve already spent significant amounts of money as hand-outs during the Covid crisis, which has resulted in elevated leverage and stretched government balance sheets. We see rising interest cost and social security burden gradually deteriorating competitivess of the developed economies.
Based on all those factors, we believe emerging economies will continue to outgrow the developed economies. After the inflation-induced hiccup in 2022, the EM/DM growth differential will increase in favour of emerging economies.
In the medium and long term, we anticipate a shift in the investment environment that will likely be decisively different to the past ten years.
Kunjal Gala
Lead Portfolio Manager, Emerging Markets
Federated Hermes Limited
Source:Federated Hermes as at 30 September 2022. The benchmark is the MSCI Emerging Markets Index. Shown for representative portfolio.
Portfolio
GHG emissions scope 1/2/3 (k tonnes of C02)
326.21
1629.4
82.24
410.8
Carbon footprint scope 1/2/3 (tones CO2 per market cap)
198.33
683.53
Carbon footprint scope 1/2/3 (tones CO2 per market cap)
Greenhouse gas emissions relative to the benchmark
Benchmark
What’s your outlook for 2023?
As global central bank action suppresses demand, the world will emerge from the initial inflation shock and the markets will rebound in 2023. And with the US Federal Reserve beginning to slow the pace of interest rate hikes, pressure on most emerging economies to act and headwinds from a strong US dollar will subside. We expect emerging markets to do well.
Chinese equities are still significantly cheaper versus history. The market can perform in 2023 if the economy reopens and policymakers successfully stabilise the property market. Having started the tightening process early, we expect several Latin American economies to ease monetary policy in 2H 2023.
Asian economies ex-China are likely to lag initially but will most probably catch up in 2H 2023 as the global slowdown begins to bottom out. We expect South Korea to benefit from stabilising global growth, considering that the market has substantially sold off in 2022. At the same time, Taiwan will remain in a tough spot from a geopolitical perspective despite a rebound in the semiconductor cycle in 2H 2023. Economies in the Middle East are likely to do well as the reopening of China stabilises global growth, driving the energy sector, which is also constrained by a long-term lack of investment and OPEC’s renewed grip on supply.
Enterprises are facing multiple challenges globally
Enterprise
(Near-term distortions, long-term changes)
Supply chain
Energy
(Near-term cost pressure, long-term implications)
Regulations
(Business model adjustments)
Climate
change
(Cost to fix)
Technology
(Strategic role in the world of data)
Central bank tightening
(Rising cost of capital)
Demand
(Mid to late cycle, long-term demographic changes)
5 key themes emerging market investors should watch out for
United States
Emerging markets forecast:
cloudy with sunny spells
Mexico
Columbia
Peru
Brazil
Chile
Argentina
South Africa
Turkey
UAE
Qatar
China
India
South Korea
Indonesia
China
Taiwan
Korea
Thailand
positive outlook
rather positive outlook
rather negative outlook
negative outlook
Poland & Hungary
UK/
Western Europe
This is for illustrative purposes only and is not a definitive list of emerging, frontier and developed market economies.
Emerging Markets
Developed Markets
In Frontier / Rest of world
1
Source: Bloomberg, as of 17 January 2023
1
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