EM supplement PB

Emerging markets find their place in the sun

ON THE BRIGHT SIDE

At a time when global growth seems likely to remain sluggish, emerging markets remain a powerful secular growth play for investors, and it is now widely accepted that the focus of this growth is shifting from industrials to domestic consumer markets. Historically, though, the price that investors had to pay for this growth was volatility. As the world looks forward to putting the Covid-19 crisis behind it, it is notable that emerging markets as a whole held up surprisingly well during the global market collapse. This supplement analyzes some of the reasons for this and delves deeper into several of the biggest growth stories out there, particularly the growing market penetration of China’s established tech sector. In the developing world there is both challenge and opportunity: emerging markets offer the potential for competitive returns over the long term, across a variety of countries and industries, and represent an important diversifier for investor portfolios. We assess the current situation of this vital area.

WINDS OF CHANGE

We look at how emergings markets are growing a new skin against all odds

sunny delights

Emerging markets are making their presence felt in the fintech revolution

CONTENTS

Time to shine

with Economic Clouds at their darkest, emerging markets offer a ray of hope

Life is not all about luxury clothes and fancy cars for the growing middle class in emerging economies. Healthcare, education, and technology are going to be the true beneficiaries of rising affluence in countries including China, Taiwan, and Brazil, and the shift is already underway. ‘The real drivers of growth are shifting – not from exports to domestic consumption, but to much more value-added activities, like intellectual property generation,’ said Raj Shant, portfolio specialist for the PGIM Jennison Emerging Markets Equity Opportunities fund. ‘It goes hand in hand with rising living and education standards, and that is really defining who the big winners are in the marketplace. It’s a less-noticed aspect of the growth and rising affluence in emerging markets.’ MIDDLE CLASSES ON THE RISE According to data from the European Commission, the global middle class is expected to reach 5.5bn by 2030, from 3.5bn in 2017. Emerging economies are anticipated to experience yearly growth of 6% or more, with China and India representing more than 43.3% of the global middle class in 10 years’ time. Such growth is leading to profound changes in healthcare provision, particularly in China, as it becomes a top priority, said Shant. ‘As the middle class grows, things like better healthcare are at the top of the heap. You see this in India and Brazil as well, where there are substantial private providers of hospital care catering to a market that can afford it and expects better healthcare than the state provides.’ The pharmaceutical industry has also experienced a shift as emerging markets (EM) have moved from manufacturing cheap generic drugs to filing increasing numbers of patents. As part of this trend, the PGIM Jennison Emerging Markets Equity Opportunities fund, which has returned 44.6% over one year, compared to its peer group’s 11.7% performance, has invested in Chinese pharmaceutical company Jiangsu Hengrui Medicine, which is in its top 10 holdings. This development is being driven by rising standards of education, said Shant, and some of the biggest opportunities are where EM companies solve local problems and then go global. That is where technology comes in. Over the last few years, emerging economies have moved from merely manufacturing smartphones to becoming among the first countries to roll out the 5G network and adopt other new technologies. ‘Increasingly we are seeing what I call “the smartphone moment” in India, Brazil, and Russia, as we saw in China 10-12 years ago,’ said Jorry Rask Nøddekær, the Citywire AA-rated manager of the Polar Capital Emerging Market Stars fund. ‘Increasingly, local companies are coming up with innovative products, providing solutions, and getting to a size and scale to become listed.’ Rask Nøddekær is seeing a wave of new technologies spreading in emerging economies, with Covid-19 acting as an inflection point for adoption. ‘We remain very optimistic about technology, both as part of the globalized supply chain and also in consumer products and adoption.’ WHEN TECH MEETS CONSUMPTION E-commerce companies, where technology meets rising consumption, have definitely come out on top. This has been due to the rise of the middle class plus changing habits of consumers during the pandemic. The Nordea Emerging Stars Equity fund, which has returned 24.7% over the last 24 months, compared to a sector average of 5.1%, has taken advantage of this trend with an overweight position in businesses such as Chinese technology company Alibaba and Indian consumer goods company Hindustan Unilever. ‘It’s a key area for us, and we’re finding interesting ideas,’ said fund co-manager Juliana Hansveden. ‘For example, Chinese sportswear as a subsegment is underpenetrated, but it’s growing significantly. This is being driven by an adoption of healthy habits and a focus on local brands such as Li-Ning.’ However, Hansveden warned that not all consumer-focused companies will be able to capture growth. She stays away from parts of the market that are already relatively mature, including beverages and noodles. Instead, the fund has invested in Foshan Haitian, a Chinese company that produces sauces and flavorings, including soy sauce. ‘We like the premiumization [of products], and increases in prices and margins will be supported from that.’ A NOTE OF CAUTION While the rising middle class in EM presents a number of opportunities, Polar Capital’s Rask Nøddekær cautioned that success is not guaranteed. Korea and Taiwan in northern Asia have been successful and have not been ‘caught up in the middle-income trap.’ This is mainly due to a focus on education, which has allowed them to increase productivity and create a labor force that can drive the growth of sectors such as technology. However, for countries that have benefitted from a commodity boom in the past but haven’t invested in education, there is a high risk of failure, said Nøddekær. Large parts of Latin America and several Middle Eastern countries are cases in point. ‘There will be a small group that will be moving into that middle-income consumer sector [in these countries], but there will also be a segment of the population caught in a low-income job who will never reach the middle-income level. ‘We would definitely say never buy the benchmark because you risk getting a lot of that negative exposure where there is a high risk for future growth dynamics. We have the feeling there will be a number of countries that are at risk of failing.’

TIME TO SHINE

SWEL

SELIN BUCAK

Emerging markets offer a silver lining in a challenging outlook, but who are the real winners?

ON THE BRIGHT SIDE

KATHRYN SCHINDLER

CONTENT WRITER CITYWIRE kschindler@citywire.co.uk +44 (0)20 7840 5153

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CHAPTER 2

PORTFOLIO MANAGER, ARTISAN PARTNERS SUSTAINABLE EMERGING MARKETS TEAM

The MSCI EM Index has become more concentrated in recent years, a trend that has intensified during the COVID-19 pandemic. At the end of Q3 2020, the cumulative weight of the three largest countries was 59%, up from 45% 10 years ago, and a similar trend has occurred at the company level. Meanwhile, the number of index constituents has increased nearly 70% over the past decade. We attribute greater index concentration to multiple factors: the combination of China’s emergence with the MSCI’s inclusion of China A-shares, differences in the development of cutting-edge industries across EM countries, geopolitical events, as well as the persistence of boom/bust cycles in many EM peripheral countries. Increased consideration of environmental, social and governance (ESG) factors may also be contributing to EM index concentration. Negative screens and exclusion lists remain a mainstream way to add ESG into an investment process. While straightforward, such methods can eliminate industries or countries from an investor’s opportunity set. VIEW GRAPH > MSCI Emerging Market Index Weights As investor focus has seemingly narrowed, we keep looking for opportunities in overlooked EM areas. Russia is a prime example—it is easy for investors to concentrate on the country’s political challenges. We believe these negatives overshadow proper macroeconomic management and improved corporate responsibility. Current fiscal rules have helped dampen the impact of oil price volatility on Russia’s currency and inflation, while a floating currency—whose movement is less influenced by oil’s price swings—has provided the central bank more flexibility to reduce interest rates when needed. At the same time, Russian companies—even state-owned enterprises—have improved stewardship of shareholder’s capital, which has led to smarter capital investments, greater willingness to return capital to shareholders, more efficient operations and higher returns on capital. These trends have reduced debt costs, improved earnings and lowered equity costs. From an industry perspective, EM investors are focused on a handful of large e-commerce and digital technologies companies which operate primarily in China. While we agree these companies have attractive fundamentals and growth stories, we are equally focused on companies in other regions. MercadoLibre is Latin America’s leading online commerce platform, including online financial technology products. As consumer penetration has increased, the company has maintained strong operational efficiency while expanding its internal infrastructure and logistics systems. The COVID-19 pandemic has shown Mercado is on the right path. As lockdowns led to a surge in demand, Mercado was able to keep operating smoothly, while a number of competitors experienced significant order-fulfillment problems with their outsourced logistics providers. Mercado is also succeeding at developing and converting customers to digital payments. Our ESG approach also seeks companies with sustainable growth and earnings within all industries. We evaluate EM companies individually and focus on the long-term direction and degree of change across multiple ESG-related factors. Truly sustainable opportunities—compelling on both an ESG and a fundamental basis—are best found by constantly monitoring for improvement or deterioration. We have witnessed firsthand companies in “bad” industries make significant strides to improve their environmental impact, transition to more sustainable businesses, be positive employers and contribute to their communities. Within EM, one must look beyond an industry classification or country of domicile and assess to what degree a company is exercising good stewardship toward all its stakeholders. Metals and mining companies Norilsk Nickel and Vale—the world’s largest high-grade nickel producers—are cases in point. A rapidly growing amount goes into lithium-ion (Li-ion) batteries for electric vehicles (EV)—which helps reduce carbon emissions. From an investment standpoint, we believe the rapid growth in electric vehicles can be a source of sustainable growth for nickel producers as the underlying battery technology is similar across all current EV manufacturers. While mining has unavoidable environmental impacts and in the past, neither company gave much consideration to the environmental impact of their operations, we believe Norilsk and Vale have embarked on genuine cultural transformations. Strong reactions against the companies’ environmental track records from governments, local communities, employees and shareholders prompted the change, but we have seen evidence of genuine commitment to cultural transformation. In May 2020, a diesel fuel leak occurred at a Norilsk power plant due to thawing permafrost. Norilsk promptly informed the government, and management was available to answer investor concerns. Norilsk put in place a comprehensive remediation plan and set aside $2 billion to reverse the damage and avoid other spills by safeguarding similar buildings. The spill highlights how natural resource companies are at the forefront of responding to climate change; they will be forced to adjust operating practices and become more active in addressing environmental challenges. Vale’s current CEO and management have also committed billions of dollars to rectify past tailings-dams failures, including reparations to local communities. We believe it has undertaken a genuine transformation that places the highest priority on sustainability. Vale is exiting coal mining, is shifting toward iron ore products for low-carbon steel-making and has a goal to reduce its green-house gas emissions. In addition, as COVID-19 began spreading in Brazil, Vale was one of the first companies to provide protective materials. While some investors appear to be narrowing their opportunity set within EM, we believe a time-tested process for finding companies focused on enhancing long-term shareholder value with a business model committed to both profits and progress can enable an investor to identify the best EM candidates wherever they are.

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SEARCHING FURTHER AFIELD: OPPORTUNITIES IN OVERLOOKED AREAS OF EMERGING MARKETS

Disclosures: Current and future holdings are subject to risk. Equity investing involves risk, which will cause your principal value to fluctuate with market conditions and may result in a loss if sold. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. These risks typically are greater in emerging markets. Such risks include new and rapidly changing political and economic structures, which may cause instability; underdeveloped securities markets; and higher likelihood of high levels of inflation, deflation or currency devaluations. This material represents the views of the portfolio manager as of 6 November 2020. The views and opinions expressed are based on current market conditions, which will fluctuate and are subject to change without notice. While the information contained herein is believed to be reliable, there no guarantee to the accuracy or completeness of any statement in the discussion. MercadoLibre, Norilsk Nickel and Vale are current holdings in accounts managed by the Artisan Sustainable Emerging Markets Team. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual securities. Any forecasts and security examples contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. MSCI Emerging Markets Index measures the performance of emerging markets. This material is provided for informational purposes without regard to your particular investment needs. This material shall not be construed as investment or tax advice on which you may rely for your investment decisions. Investors should consult their financial and tax adviser before making investments in order to determine the appropriateness of any investment product discussed herein. Artisan Partners Limited Partnership (APLP) is an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Artisan Partners UK LLP (APUK) is authorized and regulated by the Financial Conduct Authority and is a registered investment adviser with the SEC. APEL Financial Distribution Services Limited (AP Europe) is regulated by the Central Bank of Ireland. APLP, APUK and AP Europe are collectively, with their parent company and affiliates, referred to as Artisan Partners herein. © 2020 Artisan Partners. All rights reserved.

MARIA NEGRETE-GRUSON

WINDS OF CHANGE

BAILEY McCANN

Investors cannot read emerging markets in the same way they could 10 years ago. We look at how the region is growing its new skin against all odds

CHAPTER 3

PORTFOLIO MANAGER, TCW

1. How are emerging markets countries navigating COVID? The economic impact of and policy prescriptions for COVID-19 have varied widely among the 70+ countries in the EMBI index. In general, monetary policy was eased, both through rate cuts and quantitative easing, and some governments employed select fiscal measures. Because of the large number of citizens in EM countries who lack savings or ability to work from home, there have been far more limited economic shutdowns in response to the pandemic than in the developed world. We expect EM growth to exceed DM growth in both 2020 and 2021 with China the only major country – EM or DM – expected to generate positive growth this year. EM sovereign debt to GDP has increased since February, but it’s important to note that sovereign balance sheets at the start of the crisis were much stronger in EM than DM. Debt to GDP is less than half that of developed markets and is growing more slowly. Since a significantly higher percentage of EM debt is now denominated in local currency rather than dollars, policymakers can allow their currencies to weaken to jumpstart growth without significantly increasing balance sheet liabilities. Finally, USD interest rates are at historical lows and likely to remain so for the next 12 to 18 months so debt service levels are much more manageable than was the case during the Asian crisis or the 2008 financial crisis. 2. What is your view on the US dollar and how do you think about hard currency versus local currency assets? Rising fiscal and current account deficits in the US traditionally put downward pressure on the dollar all other things being equal. In the last few years, however, the impact of growing deficits has been offset by foreign inflows attracted by higher real yields in the US than in other developed markets. As the Fed has reduced rates, this differential has contracted, and as such, the attractiveness of the dollar has declined. USD weakness so far has been largely expressed against DM currencies, particularly the Euro. In order for EMFX to take a sustained lead against the dollar, we likely will need to see a continued recovery in global growth. The dollar is largely a countercyclical currency, and EM tends to outperform early in the business cycle. We believe we are coming out of the COVID lockdown induced recession led initially by China, which should benefit EM. Finally, while it is difficult to time the turn, dollar-cycles tend to be longer-term in nature. While there may be some choppiness in the near term as the dollar tends to be a safe haven during periods of volatility, we believe that EMFX opportunities are being created going into next year. 3. Emerging market sovereign spreads have tightened since the wides in March. Is there still value in emerging market debt? We think the asset class still has value both on a standalone basis and relative to other fixed income asset classes. First, global growth is turning and EM benefits from stronger growth. More importantly, an increasing proportion of EM is levered to growth in China. China has benefitted from being first in and first out and is the only major economy we expect to have positive growth in 2020. We are closely monitoring the recent increase in COVID-19 cases in Europe, and while European growth may stagnate in the fourth quarter, we do not believe the overall improving growth story will be derailed, particularly as the ECB has a significant amount of stimulus that it has not yet deployed. If this stronger growth in the rest of the world, along with growing structural deficits in the US, leads to a weaker USD, that could drive commodity prices higher and provide a further tailwind to EM. Second, balance sheets at the start of the crisis were much stronger in EM than DM and have been deteriorating at a slower pace on the back of COVID related spending. Finally, EM valuations are still attractive relative both to history and to other fixed income asset classes. With the Fed on hold until 2024, the search for yield is likely to continue for some time. The long term average spread for the sovereign debt index is around 300 bps over US Treasuries compared to today’s index spread of 450 bps. And with over 65% of global fixed income yielding below 2%, and 80% of DM government debt yielding less than 50 bps, EM is one of the only carry opportunities left. 4. What are some of the main risks that concern you? The most obvious negative tail risk facing EM today is global backsliding on the containment of COVID 19 as economies reopen. While lockdowns have proven effective for containing infection rates, they come at a substantial economic cost. A related risk is disappointment with finding, producing and disseminating an effective vaccine. Markets appear to believe that a vaccine will be approved later this year and widely available in 2021. If that optimism fades, this could have a powerful negative effect on sentiment across the global economy and financial markets. 5. How are your portfolios positioned in the current environment? Overall, our larger overweights are in countries we believe to be more resilient, due to a combination of either better credit fundamentals, more fiscal flexibility, and/or a greater ability to navigate the economic and health challenges of COVID-19, or where valuations more than reflect risks. We are seeking to avoid those sovereigns that we believe will have longer-term issues as fiscal deficits increase. The corporates we own are those that we believe can navigate this challenging environment; those that we believe are more vulnerable we exited earlier in the quarter. In our total return portfolios, we have no exposure to local currency debt at this point, given the yield advantage of hard currency debt. At the moment, given the recent increase in COVID-19 cases, our local currency portfolios are focus on idiosyncratic opportunities and relative value. As pre-election volatility declines, and the global growth story is confirmed, we would likely look to add more high yield beta to the portfolio.

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Finding Value in Uncertain Times

This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2020 TCW

PENNEY FOLEY

PORTFOLIO MANAGER, TCW

DAVID ROBBINS

PORTFOLIO MANAGER, TCW

Alex Stanojevic

The COVID-19 crisis has led to steep drop-offs in economic activity and significant market volatility recently. Nonetheless, it appears that we are gradually transitioning from a recessionary period to one of expansion. For investors seeking to capture this growth turn, emerging markets debt remains an asset class that has value.

The dramatic evolution of EM over the past 30 years means that investors cannot look at the sector through the same lens. Even the term ‘emerging markets’ has changed in meaning and now refers more to a benchmark classification rather than distinctive fundamental factors. Led by China, EM is now one of the most important drivers of global economic growth. And with key longer-term aspects such as urbanization, productivity, and for many EM countries, far more attractive demographics, opportunities for investors abound. The transition of China from a manufacturing-led economy to a service-led economy is changing the perception of EM: over the last five years, the relationship between commodity prices and EM equities has weakened significantly, while information technology, the internet, and consumption have taken over. But it has not been all rosy for the sector. Significant headwinds, including the bursting of the commodity bubble, China’s slowdown, weak global exports, and the strong US dollar, have meant having to adapt your style of investment. The sector has also experienced a narrowing of the economic growth premium compared to developed markets, while corporate earnings growth has been weaker due to a combination of cost pressures, including wage growth and softening demand. Currently, it faces a two-pronged threat – from trade tensions between the US and China, and from the global health crisis. The coronavirus pandemic has negatively impacted EM currency markets and exacerbated the general sense of unease. The EM sector has not seen the same gains that the US market has, but there are still many positive options for EM equities while remaining selective. On the bond side, with roughly $15tn in developed market debt offering negative yields, EM debt remains attractive, especially EM corporates. ‘Many regions and sectors offer defensive qualities that can outperform other asset classes during periods of risk aversion,’ says Andrew Keirle, Global Emerging Market portfolio manager at T Rowe Price. ‘EM corporate debt is now a larger market than US high yield or EM sovereigns, with over $2tn in bonds across 50 countries.’ NEW OPPORTUNITIES Within this scenario, where is the next wave of EM opportunities coming from? Scott Berg, Global Equity portfolio manager at T Rowe Price, says that 2020 is going to require ‘some nimble movement’ in portfolios, with the most interesting areas to be found in demographically driven areas such as India, Indonesia, the Philippines, Vietnam, and Peru. The growing population and consumer-led lifestyle of these countries create a favorable backdrop for higher pricing power, positive real interest rates, and stable inflation. This is a fertile environment for traditional banks and consumer companies to prosper, says Berg. On the other hand, given the less bullish outlook for commodities, the fund manager is underweight in commodity-levered economies such as Russia, South Africa, Brazil, and the Middle East. ‘Within very selective pockets of these economies, we are focused on companies with growth leveraged to positive consumer trends and emerging technologies, including electronic payments. High-quality balance sheets, low-cost production, and better growth profiles remain our compass in tougher neighborhoods.’ Turning to specific companies, investors should think carefully about who is profiting from EM economic growth. This often gets overlooked, says Vaishali Lara Kathuria, an EM equities analyst at Norges Bank Investment Management. ‘While investors might be quick to identify the income effect of economic growth in EM (for example, when disposable income increases, people tend to obtain bank accounts), they tend to overlook how consumer preferences change,’ she says. As part of their analysis, EM investors should consider the opportunities of digital innovations, particularly those that address existing bottlenecks. With their enterprising young populations, freed from tradition and legacy, EM countries are eagerly embracing technologies in the fintech arena and creating miniature versions of Silicon Valley, from Jakarta to Nairobi. FROM GLOBAL TO LOCAL Overall, with this ongoing trend towards more domestically driven economies, EM fundamentals are becoming more localized, making broad generalizations about the asset class less relevant. One only needs to look at performance on a country‑by‑country basis to see that they cannot be viewed under one homogenous banner any more. This ongoing change represents both a challenge and an opportunity. The playbook for allocating to EM equities and bonds is no longer solely cyclically driven. If in the past asset managers were posing questions on global growth, commodity prices, and EM currencies, today the picture is more complicated. While these factors are still important, they are part of a much broader mosaic. The past trajectory of EMs and winners at the individual security and country levels will not be the same going forward. A deep understanding of the opportunities and thoughtful security selection will be key to delivering results in these markets.

SUNNY DELIGHTS

STEPHANIE HOPPE

Emerging markets are making their presence felt in the fintech revolution

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Fintech providers are able to fill gaps in a market that has primarily catered to wealthy individuals while overlooking the needs of the less well-off. It therefore comes as no surprise that EM, which has traditionally suffered from limited availability to financial services, is benefitting greatly from new technologies in the financial sector. ‘Fintech is finding a natural home in EM, where the penetration of banking and insurance services is typically low,’ says Gonzalo Pángaro, Emerging Markets Equity portfolio manager at T Rowe Price. Incorporating previously underbanked individuals into the financial system, however, is no mean feat. But Pángaro says the rapid proliferation of mobile phones and improving internet connectivity make EM a fertile ground for alternative banking solutions. MOVING AT SPEED EM is eager to embrace new technologies, an area that represents a vital ingredient when unlocking the potential of fintech tools. A report by Ernst & Young suggests that China and India are leading the way, with a fintech adoption rate of 87%, closely followed by Russia and South Africa, both with 82%. Key businesses that help drive the access to fintech include large e-finance innovators such as Ant Group and WeBank. Ant, an affiliate of the Chinese e-commerce giant Alibaba, offers a range of financial services, including third-party payments and wealth management. It also plans to provide cloud-based services, big data analytics, and loan origination. Tencent’s WeBank harbors similar ambitions. The firm was among the first challenger banks to receive a banking licence and is China’s first online-only bank. Both Ant and WeBank demonstrate that the lack of a traditional financial infrastructure, which is based on bricks-and-mortar banks and conventional payment methods, can be a blessing in disguise in the fintech space. After all, integrating the latest technological advances into the financial system is much easier when it is not necessary to break down existing structures first. Low levels of credit and debit card penetration can be a stimulus for digital innovation. This led the way for digital wallets, which have become popular in emerging economies. Companies such as Alibaba and Tencent, which are growing at an extraordinary rate, have benefitted greatly from the development. This can be seen most clearly during Chinese New Year, when an increasing number of children and young adults who would once have been given hongbaos – red envelopes containing cash – now receive their gift of money virtually via mobile apps. In 2019, 823 million people – more than twice the population of the US – used the hongbao feature in Tencent’s WeChat over Chinese New Year. ‘Historically, credit card penetration has been low in emerging markets, but now many consumers are leapfrogging straight to mobile payments,’ says Pángaro. ‘Mobile payments account for around 75% of online payments in China. In the US, it is only 20%.’ REDFINING THE RULES Mobile and cloud technologies can also help address payroll problems. Firms such as M-Pesa, a mobile money transfer service based in Kenya, have been in the vanguard in that regard: employers can now pay their workers electronically, even if those workers do not have a bank account. Africa is the global leader in mobile money, which has become an important component of its financial services landscape. Mobile network operators have dominated mobile money services in Africa for the past decade. More recently, however, fintech companies have established a solid footing in the market, and several banks are now competing aggressively for the mobile banking customer. While some banks have chosen to go it alone, others are forming partnerships in the hope they can reach the market faster. These companies span the full spectrum of financial services, from payments and current accounts, to savings, loans, investments, and insurance. A little over half of the 282 mobile money services operating worldwide are located in sub-Saharan Africa, according to the GSMA, an industry organization that represents the interests of mobile network operators worldwide. US-based management consulting firm McKinsey suggests there are 100 million active mobile money accounts in Africa. This far exceeds customer adoption in South Asia, which is the second-biggest region for mobile money in terms of market share, with 40 million active mobile money accounts. ‘Up until recently it has been incredibly difficult for migrant workers in Nairobi to send wages back to their family in the countryside. Now they can do so at the touch of a button,’ says Ross Teverson, Head of Strategy on Emerging Markets at Jupiter. ‘The world economy continues to enjoy a long runway on its steady transition from cash to digital payments. Like much of the fintech revolution, this represents a significant potential for disruptors with newer technologies and innovative product offerings.’ The potential for software-enabled payments is vast and could cause an upheaval in the payment industry. Up to now, the first step in a merchant’s life involved a trip to the bank to seek financing to start their venture. A payment-processing product was therefore a natural cross-sell for banks. Today, merchants start their journey by choosing software that will help them to manage their new business. That change is driving a shift in payment distribution away from banks to software-enabled payment providers. DRIVING GROWTH The payments industry has more room to grow. In addition to software-enabled payments, it is also business-to-business (B2B) payments that will cause a stir in the fintech sector. B2B is a multitrillion-dollar market that rivals the consumer payments industry in size. According to Ernest Yeung, Emerging Markets Discovery Equity portfolio manager at T Rowe Price, the sector is just beginning to gravitate towards more modern payment technologies and away from manual processes. This could drive growth for the payments industry for many years to come. As Yeung put it: ‘The fintech revolution is here to stay.’

Head of Emerging Markets Debt Team, William Blair

The emerging markets (EM) debt universe entered 2020 on a strong footing amid rising prospects for a global cyclical upswing. A combination of factors—economic growth rising above potential, improving fiscal dynamics, external account surpluses, and only moderately increasing levels of public debt—were expected to support the case for lower credit spread levels. Low inflation expectations and high local real interest rates in most countries indicated scope for monetary stimulus. And growing consensus around rising economic growth differentials relative to developed economies underpinned expectations for a sharp pickup in capital flows into EMs. This combination of factors pointed toward a very good year for the asset class. Then COVID-19 struck. Fiscal Deterioration and Challenging Global Macroeconomic Conditions Collapsing economic activity has resulted in a significant loss of fiscal revenues in EMs. We believe the average fiscal deficit-to-GDP ratio in the investable universe (represented by the JP Morgan EMBIGD) will be about 8.5% in 2020 and 5.7% in 2021, up from 3% in 2019. This significant fiscal deterioration will likely result in increased debt levels. We believe the total public-debt-to-GDP ratio will increase to about 60% in 2020 and 2021, up from 50% in 2019. Most of the additional issuance of public debt, however, will take place in domestic markets. We expect the foreign-debt-to-GDP ratio to increase more moderately, from 25% in 2019 to about 26.5% in 2020 and 2021. Therefore, most of the fiscal expansion will be financed by the issuance of local currency debt. At the same time, the International Monetary Fund (IMF) forecasts a global economic contraction of 4.4% in 2020. While the IMF anticipates a recovery of 5.2% in 2021, the level of economic output seen before the crisis is not expected to be achieved until 2022 or 2023. Furthermore, there is a higher-than-usual degree of uncertainty around these forecasts. The evolution of the COVID-19 pandemic, U.S.-China relations, and rising geopolitical tensions in Europe and the South China Sea all pose significant risks. But despite these challenging conditions, there are reasons to be optimistic. Ample Global Liquidity Conditions Help Offset Negative Global Risk Factors Through a combination of quantitative easing and interest rate cuts, central banks have provided massive monetary stimulus to the global economy. This has created an unprecedented expansion of the monetary base, leading to a very favorable liquidity environment. In this environment, global interest rates have also fallen to historically low levels, resulting in favorable refinancing conditions for EM debt issuers. Ample liquidity conditions, together with strong support from multilateral and bilateral organizations—such as the IMF, World Bank, regional development banks, G20, and China—means that available funding should continue to limit the scope for technical defaults. Multilateral and Bilateral Support Come to the Rescue At the same time, multilateral and bilateral support have provided EM economies with financial aid and liquidity as well as guidance on the implementation of economic reforms to ensure that countries more optimally use their resources, collect revenues, and control expenditures. As of September 2020, the IMF is providing financial assistance and debt service relief of approximately $250 billion to member countries suffering as a result of the pandemic. This assistance could rise to as much as $1 trillion through a combination of quotas, multilateral borrowing arrangements, and bilateral borrowing agreements. The World Bank has supplemented IMF support with financial assistance of its own, providing up to $160 billion of financing to more than 100 developing countries since April 2020. The G20 has also coordinated debt relief to EMs under the Debt Service Suspension Initiative (DSSI), which provides an estimated $11.5 billion in debt-service relief to EMs suffering from economic hardship as a result of COVID-19. China, an important bilateral lender, is working with the G20 on the DSSI and is expected to be responsible for approximately half of the debt relief provided under this initiative. Although there will be exceptions, we believe this support will be effective in ensuring that we do not see a large number of debt restructurings across EMs in the coming years. Technical Conditions Have Improved Despite Rising Debt Issuance While market volatility remains elevated and bid-ask spreads are still wide, technical conditions have improved as flows into EM debt portfolios have continued to rise over the past months. Investor flows into the asset class should offset a seasonal pickup in net issuance of new debt. Valuations Are Still Attractive We also believe valuations are attractive. Massive forced selling from passive EM debt funds in March 2020 created significant price dislocation, especially in the less-liquid, high-yielding part of the investable universe, and prices have not fully normalized. The spread between the high-yield and investment-grade components of the JP Morgan EMBIGD is currently at 550 basis points (bps) as of mid-October, above the peak seen during the Global Financial Crisis. EMD spreads also screen very attractively relative to developed-market credit. At current levels, we believe EMD credit spreads overcompensate investors for credit default risks. The Bottom Line: No Systematic Crisis Brewing Despite some challenges, the overall fundamental story in EMs remains largely intact. While there has been clear credit deterioration in many countries, credit metrics remain at much healthier levels than those of advanced economies. And we do not see evidence that would suggest a systemic crisis is brewing in EMs. Historically, EM crises are driven by unsustainable debt dynamics, currency crisis, or financial sector disruptions. That is not the case today. EM debt levels have grown only moderately, generally concentrated in the Chinese corporate sector. Most EMs have rebalanced their external accounts since the 2013 taper tantrum and now have healthy basic balances, with improved external accounts, rising international reserves, and undervalued currencies indicating strong external resilience. Lastly, the EM financial sector is overall well capitalized and regulated, with very few exceptions. The bottom line is that we remain constructive on the outlook for EM debt. While the global economic recovery remains clouded by uncertainty around COVID-19, strong fiscal and monetary policy response, ample global liquidity conditions, multilateral support, rising inflows, and attractive valuations all point to the potential for further EMD spread compression in the near term.

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EMD Outlook Optimistic Amid Uncertain Times

This content is for informational and educational purposes only and not intended as investment advice or a recommendation to buy or sell any security. Information and opinions expressed are those of the author and may not reflect the opinions of other investment teams within William Blair Investment Management, LLC, or affiliates. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Information is current as of the date appearing in this material only and subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. This material may include estimates, outlooks, projections, and other forward-looking statements. Due to a variety of factors, actual events may differ significantly from those presented. Investing involves risks, including the possible loss of principal. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. The JP Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) tracks the total return of U.S.-dollar denominated debt instruments issued by sovereign and quasi-sovereign entities. It is not possible to directly invest in an unmanaged index. Past performance is not indicative of future returns.

Marcelo Assalin, CFA

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CHAPTER 3

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CHAPTER 2

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