At a time when global growth seems likely to remain sluggish, emerging markets remain a powerful secular growth play for investors, and it’s 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 emerges from the Covid-19 crisis, it’s notable that emerging markets as a whole held up surprisingly well during the market collapse of the first quarter. This supplement analyzes some of the reasons for this and delves deeper into some of the biggest growth stories out there, particularly the growing market penetration of China’s established tech sector. It also questions what types of investment approaches are likely to perform in a post-Covid-19 market environment. ESG, one of the biggest themes in the investment world, is now well established in developed markets. But in the developing world there is both challenge and opportunity: ethical investing has the chance to have a tangible effect on the lives of millions, but it still faces a number of hurdles, particularly in areas such as transparency and reporting standards. We assess the current situation of this vital area.
Napoleon knew it all along. More than 200 years ago, the French emperor compared China with a sleeping giant who, when awake, would ‘move the world’ – and boy, was he right. Far from being sluggish, the country entered the international playing field with a vengeance and is now a leading actor on the global stage. China’s investment sector had a tough time keeping up with the blistering speed of development. For years, tough restrictions posed a significant hurdle for international investors looking to capitalise on the burgeoning economy. But things are about to change as the country is carefully cracking the door open to the rest of the world. ‘China’s capital markets are a lot more accessible to foreign investors now than they were a decade ago,’ said Anuradha Gaggar, senior investment research analyst at Commonwealth Financial Network. It is not just the revamped approach on regulatory barriers that increases the country’s investment attractiveness. With innovation in the tech space roaring ahead, the world’s second-largest economy has some aces up its sleeve that make it a force to be reckoned with.
China’s big three lead the race for tech supremacy
‘Ten years ago, China’s tech sector was still quite basic and concentrated on key services such as ecommerce, internet advertising and online gaming,’ said Benjamin Cavender, managing director of the China Market Research Group. ‘Now, companies like Alibaba, Tencent and Baidu are propelling the Chinese tech revolution.’
Ecommerce giant Alibaba is successfully tapping into the growing O2O market by blending digital and physical shopping with its highly technologized supermarket chain Hema. Coined as ‘New Retail’ by Alibaba’s co-founder Jack Ma, the stores boast a variety of AI elements, including facial recognition payments and electronic shelf labels that allow for dynamic pricing. ‘Whether it’s about improving a customer’s purchase journey or identifying future consumption trends, at the end of the day, it all comes down to making the most of the data you have. That’s where you see Chinese tech companies starting to jump ahead of the Amazons and Googles of the world,’ Cavender said. Cloud computing represents another area, where China’s tech elite can lead the way. Both Alibaba and social media and gaming group Tencent intend to increase their stance in the cloud business by beefing up their cloud computing division with ambitious investment plans. Baidu is looking for opportunities elsewhere. China’s largest search engine has ventured into the autonomous driving sector and continues to invest heavily in Apollo, its autonomous vehicle platform. The company has long become the poster boy for a new mobility trend. A McKinsey report from 2019 suggests that driverless cars could take over most of the automotive market in China, with players in the industry poised to ‘earn trillions in revenues.’
While he acknowledged that there are a lot of smaller start-ups, he also pointed out that 80% of investments in Chinese unicorn companies are coming from one of the big three: ‘All the power really does flow through this very small number of companies.’ Chelsey Tam, senior equity analyst at Morningstar, sings the same tune. In her opinion, Alibaba, Tencent and Baidu serve as ‘trend indicators’ for the next big topics in the tech space, so investors do well to ‘pay close attention to their business decisions.’ With a combined market capitalization of more than $1tn, the trio dominates the country’s digital economy, although the respective level of influence differs within the group. ‘I feel like it’s almost the big two now, with Baidu trailing behind Alibaba and Tencent a little in terms of its relevance to the average person on a daily basis,’ Cavender said. ‘If you look at where investments are happening today, it’s online-to-offline (O2O) and offline-to-online commerce.’
Covid-19 triggers tech boom
But China’s tech industry is about more than autonomous driving, cloud computing and innovative ways of doing ecommerce. While the coronavirus crisis has left its marks on the economy, it has also become a boon for the tech space. According to Tam, Covid-19 ‘increased the online adoption of grocery and fresh produce purchases.’ Food delivery services such as Tencent-backed Meituan Dianping and JD Fresh, the food division of ecommerce platform JD.com, experienced a surge in orders that has sent their share prices skyrocketing. Meituan hit the $100bn valuation mark in May, while JD.com stocks soared to a 52-week high of $59.82 in the second week of June. Both Tam and Gaggar agree that Edutech represents another area that stands to benefit from the pandemic. Cavender echoes her view: ‘Covid-19 has a huge impact on online education. Over the next couple of years, we will probably see a lot of disruption in that area. There’s a big potential for growth and revenue generation as people switch to more of these online formats.’
In his opinion, companies like New Oriental will emerge as winners from the crisis. During the throes of China’s lockdown between January and March, the New York-listed education firm reported a 15.9% increase in revenue to $923.2m, thus beating expectations from analysts who forecasted revenue of $918.7m. ‘New Oriental has always been very focused on classrooms, but it now has invested a lot of money into building digital systems. We’re going to see a shift where old-school companies move into the digital space,’ Cavender said. Streaming providers are in for a treat as well. ‘What we currently see in China is like nothing we have seen in other markets in the world, with Covid-19 speeding up the trend toward live streaming. Take clothing stores as an example: during the lockdown, they were able to basically get rid of all their old inventory by having their staff livestream the products on their personal WeChat accounts,’ Cavender said. Just like Tencent’s WeChat, ByteDance is also benefitting from that development. The company’s video sharing platform TikTok has seen its number of users explode since the beginning of the lockdown. Mike Vorhaus, CEO of the digital media consulting company Vorhaus Advisors, thinks TikTok is here to stay. In his opinion, the app is set to ‘grow substantially’ and will ‘quite possibly reach the longevity of YouTube.’
Millennials are shaping the market
A lot of that success can be chalked up to millennials. While the coronavirus crisis turned out to be a catalyst for the increasing digitization of daily life, those born between 1981 and 1996 have been fuelling the shift toward an online economy for years. According to a survey by KPMG and retail site Mei.com, 74% of China’s millennials, which make up a quarter of the country’s population, are ‘interested in innovative products and services associated with emerging technologies.’ ‘The number of Chinese millennials exceeds the current population of the US, so tech companies simply cannot afford to ignore them,’ Gaggar pointed out. According to Morningstar’s Tam, they are also more willing to pay for online content, which will ‘prove advantageous for video and music platforms alike.’ Cavender sees it similarly: ‘Millennials are hugely important for China’s tech companies. The consumer that everybody wants is a woman between the ages of 18 and 35: She’s not only making buying decisions for herself but also for her partner and kids, maybe even for her parents.’ ‘From a tech company’s perspective, you absolutely have to win over millennials, especially women. If you don’t, you won’t have a consumer base. You can’t build a tech business in China unless you get this group to actually spend money,’ he said. Unsurprisingly, China’s tech sector is scrambling to cater to the needs of the 25- to 39-year-olds, and with sustainability increasingly becoming a main priority for a rising number of millennials, sharing platforms are booming. ‘Buying and selling second-hand goods has become an emerging trend in China. A lot of younger people are critical of overconsumption and want to live a more balanced life,’ Cavender said. As a result, resale sites like Alibaba’s Idle Fish are in for a treat. According to the Sootoo Institute, a Beijing-based research firm, more than 60% of users of China’s largest second-hand marketplace were born after 1990.
The signs point to growth
Even though China’s tech revolution is already well underway, it is gaining additional firepower from the accelerating trend toward deglobalization and the US-China trade war. ‘China had already embarked on its journey to more self-sufficiency, but the trade war is pushing that development even further. As a consequence, the speed of innovation increases,’ Gaggar said. ‘Chinese companies are no longer just followers. In many areas like healthcare and software, they are about to become leaders that will leave their US peers behind. Change is coming.’
‘Ten years ago, China’s tech sector was still quite basic and concentrated on key services such as ecommerce, internet advertising and online gaming,’ said Benjamin Cavender, managing director of the China Market Research Group. ‘Now, companies like Alibaba, Tencent and Baidu are propelling the Chinese tech revolution.’ While he acknowledged that there are a lot of smaller start-ups, he also pointed out that 80% of investments in Chinese unicorn companies are coming from one of the big three: ‘All the power really does flow through this very small number of companies.’ Chelsey Tam, senior equity analyst at Morningstar, sings the same tune. In her opinion, Alibaba, Tencent and Baidu serve as ‘trend indicators’ for the next big topics in the tech space, so investors do well to ‘pay close attention to their business decisions.’ With a combined market capitalization of more than $1tn, the trio dominates the country’s digital economy, although the respective level of influence differs within the group. ‘I feel like it’s almost the big two now, with Baidu trailing behind Alibaba and Tencent a little in terms of its relevance to the average person on a daily basis,’ Cavender said. ‘If you look at where investments are happening today, it’s online-to-offline (O2O) and offline-to-online commerce.’ Ecommerce giant Alibaba is successfully tapping into the growing O2O market by blending digital and physical shopping with its highly technologized supermarket chain Hema. Coined as ‘New Retail’ by Alibaba’s co-founder Jack Ma, the stores boast a variety of AI elements, including facial recognition payments and electronic shelf labels that allow for dynamic pricing.
‘Whether it’s about improving a customer’s purchase journey or identifying future consumption trends, at the end of the day, it all comes down to making the most of the data you have. That’s where you see Chinese tech companies starting to jump ahead of the Amazons and Googles of the world,’ Cavender said. Cloud computing represents another area, where China’s tech elite can lead the way. Both Alibaba and social media and gaming group Tencent intend to increase their stance in the cloud business by beefing up their cloud computing division with ambitious investment plans. Baidu is looking for opportunities elsewhere. China’s largest search engine has ventured into the autonomous driving sector and continues to invest heavily in Apollo, its autonomous vehicle platform. The company has long become the poster boy for a new mobility trend. A McKinsey report from 2019 suggests that driverless cars could take over most of the automotive market in China, with players in the industry poised to ‘earn trillions in revenues.’
Three reasons to consider emerging market stocks
Enhanced alpha potential as markets move
Why invest in emerging market (EM) stocks? Growth potential and diversification are commonly cited benefits, yet thin positioning, particularly in North American portfolios, suggests many investors are unconvinced. Three reasons to consider a rethink:
EM stocks are notoriously volatile, and most investors see this as a negative. Yet volatility is not synonymous with loss. Stocks move down … and up, meaning price drops can present opportunities to buy at attractive levels and enjoy the appreciation potential of an upturn. Over the past decade, about 65% of EM stocks moved by at least 40% annually. This implies that, depending on the entry point, a large number of companies offered the prospect of a high relative return. Skilled active managers can wade through the over 3,000 listed EM stocks in seeking to translate volatility into opportunities to generate above-market return.
Lower valuations make for an attractive entry point
We believe the current environment provides a better entry point for EM stocks relative to their U.S. and other developed market counterparts. EM valuations stood at a 47% discount to developed peers at the end of May. Corporate margins and return on capital are near lows in EMs relative to their own history and compared to the U.S. This suggests EM stocks could have more room to run, providing investors with enhanced growth potential over time.
You are very likely underallocated
EMs failed to meet investors’ return expectations in the past decade, reinforcing a home-country bias is U.S. portfolios. Yet the prior decade was very different, with EMs significantly outpacing DMs. Over the full 20 years (2001-2019), EMs came out ahead: The MSCI Emerging Markets Index notched a 9% annualized return vs. 5.5% for the MSCI World Index.* While EMs make up half of world GDP and 15% of world stock market capitalization, they represent just 4% of the average U.S. investor portfolio, as shown below. The upshot: Many investors may be missing out on the long-term potential of EM stocks.
Navigating an uneven road to recovery in emerging markets
As individual countries plot their emergence from coronavirus closures, the pace of recovery and prospective outcomes are looking increasingly diverse.
In many ways, the coronavirus pandemic has reinforced investment trends that were in place prior to the crisis. Among them: Developed markets outperforming emerging markets (EMs), technology leading all other sectors, momentum outperforming value, and U.S. stocks outpacing the rest of the world. Yet we also have seen new trends starting to emerge. This is partly because the recovery from COVID-19 and its economic shock is unlikely to be of the same magnitude everywhere. Using big data analysis to track the spread and trajectory of the virus, we have found that the experience across countries, cities and individual markets has been very different, depending on factors such as when lockdowns were put in place and enforced, how long they remained in effect, and how virus detection and antibody testing have evolved. The result has been a level and degree of dispersion not seen for some time ― and, in turn, an opportunity for active stock selection to make a bigger difference than it has in years.
In an environment where regional recovery is uneven, we see country as a unit of analysis becoming more relevant for investment decision-making. Our data covering the universe of emerging countries finds dispersion has tripled since January, reaching its highest level since the global financial crisis. We find the differing experience across emerging economies has hinged on the individual response throughout the various stages of the coronavirus crisis. For example, countries like Brazil, Russia and Mexico were slower to contain the spread of the virus with policy actions like social distancing and reduction in non-essential business activities. COVID-19 cases and deaths consequently continued to accelerate faster than elsewhere in EM, and recovery appears farther away. Meanwhile, Asian countries such as South Korea, Taiwan and China have been faring better than other EMs given the relative strength of their health care systems. Greater fortitude on the health front has facilitated re-openings, helping to stem some of the economic damage and supporting stock prices of companies that have a higher relative exposure to those countries. Further dispersion is evident in countries’ willingness and capacity to provide the fiscal and monetary policy support needed to mitigate the economic consequences of the pandemic. Countries like South Africa, Turkey, Mexico and Brazil look more vulnerable than the rest. We see current account deficits, levels of government debt and other macroeconomic indicators as factors that will separate winners from losers.
Open doors and open questions
As we approach the next phase of the COVID-19 emergency, we are looking to identify the main drivers of recovery in countries, industries and companies. Part of the challenge is in determining how permanent some of the changes in human behavior may be. Our data has found that even as countries and businesses take steps toward normalcy, with restaurants and stores opening their doors, consumers can be slow to return. Robust online transactions in China, which is farthest along in the virus trajectory and re-opening, indicate consumers may be content to stay home and have goods delivered. A look at China mobile app usage, as shown above, also is telling. Since February, the biggest bounce has been seen in job search and home purchase apps, personal priorities as economic and business activity starts to normalize. Meanwhile, rebounds in ride sharing (DIDI) and driver testing (a pre-requisite to car buying in China) may suggest a continued aversion to mass transit. A smaller recovery was seen in trip-planning app CTRIP. We expect business models that require human congregation, such as cruise lines and live concerts, are likely to face structural headwinds arising out of the pandemic. Our team has developed a framework to actively capture those tactical insights that we believe will remain relevant for as long as markets and economies are processing the effects of the coronavirus pandemic. This new input is critical in an environment where a return to work does not necessarily equate to a return to normal.
Emerging market (EM) companies that score highly for environmental, social and governance (ESG) metrics have outperformed the wider market during the coronavirus crisis and over the longer term. The MSCI Emerging Markets ESG Leaders index beat the broader MSCI Emerging Markets index by 1.5% during the first five months of the year, posting losses of 14.5% and 16% respectively. The difference is slightly more pronounced than global markets: the MSCI World ESG Leaders index has a 1.35% advantage over the MSCI World index, according to data analysis by Pacific Life Fund Advisors, which has been researching the subject. Over the longer term, the difference is far more profound. The broad MSCI EM index has risen by 27.6% in the last decade, while the MSCI EM ESG Leaders is up by 75.4% – a near 48% difference. Globally, ESG metrics offer no real advantage over 10 years. Returns from the MSCI World ESG Leaders and broader MSCI World indices are neck-in-neck at 143.7% and 143% respectively.
Risk management is chief among the reasons for the difference. Envestnet PMC, Envestnet’s portfolio consulting group, views ESG as a ‘risk lens’ when investing in EM. ‘ESG insights can offer more value in emerging markets, which tend to show greater volatility than developed markets,’ said associate portfolio manager Kiley Miller from her base in Chicago, Illinois. For Cornerstone Capital Group, companies with stronger ESG policies are better able to mitigate large scale risks – be they environmental issues, such as the cost of cleaning up years of toxic pollution, social risks like labor unrest or governance risks like weaker regulatory environments. ‘While not dismissing the importance of investing with a strong ESG lens in developed markets, I’d argue that strong ESG credentials are extremely important criteria when considering investments in emerging markets,’ said Jennifer Leonard, director of asset manager due diligence at Cornerstone’s New York City office on Fifth Avenue.
For many fund buyers, evidence of good governance is most important when investing in EMs. This provides an assurance over management quality in developing economies where poor financial reporting standards, lack of independent boards and even outright fraud remain rampant. ‘A key risk in investing in emerging market companies lies in finding companies with strong corporate governance systems as oftentimes management or even the government has a greater voice in the firm than its shareholders,’ said Mark Andraos, an associate portfolio manager at Regency Wealth Management in Ramsey, New Jersey. ‘In a similar manner, state-owned businesses tend to lack the free market discipline of developed markets as a result of greater government intervention, which ultimately leads to less innovation and productivity.’ Regency uses an active mutual fund for EM exposure. Though not a dedicated ESG-focused fund, it avoids companies that are state-owned or face governance conflicts. For example, many EM companies are predominantly owned and controlled by families. For Miller at Envestnet PMC, relevant issues to consider include ownership structure, independence of board members and audit and remuneration committee oversight. EM companies that display good governance are able to give investors confidence that their growth is real, according to Max Gokhman, head of asset allocation at Pacific Life Fund Advisors. ‘This, in turn, attracts more and stickier capital which helps these firms to continue growing,’ he said from Newport Beach, California.
Social and environmental factors are rising in prominence for consumers and investors in EMs. ‘The social pillar is seeing growth within emerging markets due to the rise of a middle class that is more cognizant and demanding of better labor practices, education and upward mobility for themselves and their lower-income compatriots,’ said Gokhman. ‘This also means that consumer discretionary companies with sustainable supply chains stand to see greater local demand.’ Environmental considerations have historically been less important for governments in developing economies; many have sought to rapidly grow their economies even if that growth came at the cost of pollution. ‘This too is changing,’ said Gokhman. ‘As more emerging nations, such as China and India, focus on clearing the air, there is increasing potential for local renewable energy, water and waste management companies to outperform with government backing as a tailwind.’ At a stock level, Rockefeller Asset Management highlights Shenzhou International Group. The Chinese clothing manufacturer operates in an industry known for social and environmental impact violations. It has surpassed peers in addressing environmental and social risks, enabling it to meet the stringent supplier standards demanded of big sports apparel brands like Nike, Adidas and Puma.
From an opportunity perspective, companies that meet sustainable criteria are better positioned to capitalize on ESG-related trends. ‘If you think about the long-term secular trend towards a low carbon global economy, away from fossil fuels and toward green technologies, emerging markets have a large role to play,’ said Rockefeller’s Clark. ‘Oftentimes, emerging markets are reliant upon the export or import of these fuels, and so those companies and countries that are at the forefront of helping with this transition have the potential to do well.’ Other thematic approaches favored by investors in EMs include access to financial services and technology. ‘Companies that provide cost-effective and fairly-priced access to financial services and technology to those who need it most in growing markets can serve as a proxy for ESG data where it may not exist,’ Cornerstone Capital’s Leonard said. Investor interest in companies that solve specific and pressing challenges is growing, driven by demographics – more younger people work and invest in EMs and have a particular interest in wanting companies to do good in the communities they serve, according to Aline Wealth, which has offices in Long Island, New York City and Florida. ‘ESG investing has morphed into mission-driven investing, which in turn has morphed into impact investing,’ said Peter Klein, its chief executive and founder. ‘More investors – be it family offices, hedge funds and, to a larger extent, foundations – are looking to put capital to work for mission-driven causes. While return is still an important result, investors are asking themselves, “what are my investments doing for the community?”’
Companies offering solutions to ethical issues are often start-ups or privately held, according to Aline. To offer access to them, it connects clients with other impact investors through organizations like Toniic, a community of 400 high net worth individuals, family offices and foundations seeking to have an impact with their capital in more than 25 countries around the world. For Adam Bendell, Toniic’s chief executive, the coronavirus pandemic provides a clear example of the difference between ESG and impact investing. ‘This is the kind of crisis impact investing was built for,’ Bendell said. ‘Instead of asking only “how do I protect myself”, Toniic members are asking “how can I help?” ‘As a result of this crisis, new opportunities will arise for impact investors and society. The crisis is driving change at a speed and innovation rate which was unthinkable months ago, and new economic and consumption models are being birthed.’ He added: ‘The pandemic has reminded even the most insular of the radical interconnectedness of life on earth – of the awesome might of private enterprise to solve big world problems; of the undeniable recent track record that, faced with an existential threat, global society can respond in ways that were out of the question shortly before.’
‘Given lower levels of transparency, sometimes weaker regulatory environments with respect to environmental and labor standards, and less of a focus on strong corporate governance in many markets, there is an increased capacity for corruption, environmental and social issues and fraud at the corporate level than is typically seen in more developed markets. Investments rooted in strong ESG criteria help guard against exposure to these risks.’
Rockefeller’s engagement with it has seen it set energy and water emissions reduction targets for the first time. ‘As the Chinese government is now enforcing a number of environmental regulations and fining or shutting down apparel factories in China, Shenzhou has been spared,’ said Casey Clark, Rockefeller’s global head of ESG investments, based in New York City. Klabin, a Brazilian manufacturer of paper, packaging and timber products, has been held in the Trillium ESG Global Equity strategy since 2015. Headquartered in São Paulo, it has 16 production facilities in Brazil and Argentina, where it exports to more than 60 countries on every continent. ‘Klabin has a culture of sustainability that directs the management of its forestland, which is 100% certified by the Forest Stewardship Council – the first company south of the equator to earn such designation,’ said Matt Patsky, chief executive of Trillium Asset Management, a Boston-based ESG investment firm.
Klabin reserves more than 40% of its forestland as native habitat to protect biodiversity and has a participative decision-making process with local communities. In aiming to mitigate its manufacturing impacts, 98% of materials used in its production processes come from renewable sources, as does 89% of the energy it uses – a figure that Trillium expects to exceed 90% in 2020.
Social and environmental factors are rising in prominence for consumers and investors in EMs. ‘The social pillar is seeing growth within emerging markets due to the rise of a middle class that is more cognizant and demanding of better labor practices, education and upward mobility for themselves and their lower-income compatriots,’ said Gokhman. ‘This also means that consumer discretionary companies with sustainable supply chains stand to see greater local demand.’ Environmental considerations have historically been less important for governments in developing economies; many have sought to rapidly grow their economies even if that growth came at the cost of pollution. ‘This too is changing,’ said Gokhman. ‘As more emerging nations, such as China and India, focus on clearing the air, there is increasing potential for local renewable energy, water and waste management companies to outperform with government backing as a tailwind.’ At a stock level, Rockefeller Asset Management highlights Shenzhou International Group. The Chinese clothing manufacturer operates in an industry known for social and environmental impact violations. It has surpassed peers in addressing environmental and social risks, enabling it to meet the stringent supplier standards demanded of big sports apparel brands like Nike, Adidas and Puma. Rockefeller’s engagement with it has seen it set energy and water emissions reduction targets for the first time. ‘As the Chinese government is now enforcing a number of environmental regulations and fining or shutting down apparel factories in China, Shenzhou has been spared,’ said Casey Clark, Rockefeller’s global head of ESG investments, based in New York City. Klabin, a Brazilian manufacturer of paper, packaging and timber products, has been held in the Trillium ESG Global Equity strategy since 2015. Headquartered in São Paulo, it has 16 production facilities in Brazil and Argentina, where it exports to more than 60 countries on every continent. ‘Klabin has a culture of sustainability that directs the management of its forestland, which is 100% certified by the Forest Stewardship Council – the first company south of the equator to earn such designation,’ said Matt Patsky, chief executive of Trillium Asset Management, a Boston-based ESG investment firm. Klabin reserves more than 40% of its forestland as native habitat to protect biodiversity and has a participative decision-making process with local communities. In aiming to mitigate its manufacturing impacts, 98% of materials used in its production processes come from renewable sources, as does 89% of the energy it uses – a figure that Trillium expects to exceed 90% in 2020.
Many investors turn to emerging market (EM) equities seeking exposure to topical trends ― or stories. They buy into ideas such as “India has a growing middle class” or “Asia is the world’s fastest-growing region.” While many of these storylines may bear out in the long run, they tend to lack predictive power for asset returns. And investors focused on these less potent drivers may be missing the larger but more opaque risks associated with the various stages of the economic cycle. HOOK, LINE... AND POTENTIAL SINKER Buying into any EM “story” means finding stock expressions to ride that narrative out to its conclusion. But investors can be disappointed when the classic buy-and-hold strategy fails to meet their return expectations. The truth is: It’s hard to find long-term winners, especially in emerging markets. We looked for companies that could consistently beat our assumptions for annual nominal gross domestic product (GDP) growth (5% in the U.S. and 10% in EM) over 10 years. Factors we considered were sales, net income, earnings per share and EBIT. Less than 5% of companies met the criteria on any one of these metrics. Some may read this to mean there is limited potential in EM stocks. To the contrary, this suggests that active, bottom-up stock selection can make a meaningful difference in EMs ― where country- and security-level dispersion in great, as is the potential for skilled managers to add alpha. NO SINGLE CYCLE We believe economic cycles, not trends, reveal opportunities in EM equities. Yet there is no single EM economic cycle. The more than two dozen countries in the popular EM universe are heterogeneous, idiosyncratic and often at different stages in their economic cycles. They also have their own currencies, can be large commodity exporters, such as Brazil and Russia, or commodity importers, such as Turkey. The fact that EMs are such a varied set means there is ample opportunity to add value through asset allocation. To assess a country’s economic trajectory, we monitor shifts in external accounts, fixed income, liquidity supply and economic activity. We have found these macro indicators to be reliable predictors of equity returns, historically contributing 20%-30% of alpha in our EM strategy. We consistently move capital from countries we believe are in a later stage of the economic cycle (activity surge) to those in an earlier stage (healing). We would rather be long a country with poor but improving macro conditions than one with a good but deteriorating economy. Understanding where countries are in their economic cycles also helps us decide whether the risk-reward favors buying the dips. Our macro research is critical to navigating EM “heart attacks” — sharp sell-offs in one or more countries. We typically see two to three heart attacks in any given year. The coronavirus pandemic may test those limits, but our research framework helps us to gauge how a country’s economy may cope with the virus and its economic fallout. EXPLOITING, NOT AVOIDING, VOLATILITY Alongside the significant country-level dispersion in EMs is a high degree of individual stock variation ― and volatility. Consider that roughly 65% of stocks in the MSCI EM Index moved at least 40% annually over the past decade (see illustration on page 8). This can be off-putting to many investors, yet volatility has two sides. “Bad volatility,” the big up and down benchmark moves, can be painful. “Good volatility,” however, is the enormous dispersion among stocks and countries, which can be fertile ground for active investing. The coronavirus shock has ensured the continuation of EM volatility into 2020. The swings have been evident not only at the broad EM index level, but in the styles within it, as shown below. On average, most EM managers tend to perform best when the growth style is in favor, as in 2019, and underperform when it is out of favor, as in 2018. Our combination of bottom-up stock selection and style flexibility allowed us to achieve return consistency regardless of broad market leadership. Stark country dispersion offered tactical opportunities to adjust our portfolios in pursuit of alpha. Our team of analysts examine and parse roughly 3,500 liquid EM stocks, focusing on companies where our view on earnings or cash flow differs from that of the broader market over a one- to two-year horizon. BEYOND COVID-19 In the economic transition to a post-COVID 19 world, we will likely revisit a low-growth, low-return environment globally. Yet the grand scale of monetary and fiscal support should underpin strong liquidity. Against this backdrop, we believe EMs can offer attractive relative growth and return potential. EM equity valuations are compelling compared to developed markets and at their lowest level on a price-to-book basis since the tech bubble of the late 1990s, as shown in the chart below. Currencies have adjusted and large-scale stimulus should put a cap on the U.S. dollar, historically a positive for the asset class. And in a world of increased dispersion, we see EMs offering more diversification benefits as correlations with DMs decline. An EM-to-DM stock correlation of 79% in the past decade represents a decline from its mid-2000s peak. The inclusion of China A shares in the MSCI EM Index, a process begun in 2018, could help to further lower these correlations. MSCI data shows the China A shares correlation to developed stocks at just 57% over the past three years. As China A shares become a larger portion of the broad EM index, this could enhance the diversification potential of EM stocks. China has provided strong relative performance among EMs during the COVID-19 crisis. While we expect the Chinese market can show continued resilience in the short-term given the government’s unprecedented stimulus package, we are looking for future market outperformance to come from other countries. In all, we remain optimistic and actively engaged to capitalize on all the emerging world may have to offer.
Flexibility matters in EMs EM style factor returns over time (relative to MSCI EM)
Source: BlackRock, as of March 31, 2020. Factor returns are based on BlackRock’s Fundamental Equity Risk model. 2020 returns are year-to-date through March 31. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole consideration when selecting a product or strategy.
Attractive entry point Price-to-book value of EM stocks, 1995-2020
Source: BlackRock, with data from Bloomberg, as of April 2020. The price-to-book ratio compares a company’s market value to its book value, or the net assets of the company. Based on data from the MSCI Emerging Markets Index. Indexes are unmanaged and one cannot invest directly in an index. Past performance is not a reliable indicator of current or future results.
Q. How long have you been investing in EMs? A. I’ve been an EM investor my entire career. 14 years. Q. What makes a country “emerging”? A. Many people think “emerging” implies something about a country’s wealth or its technology prowess. This is not the case. What really defines an emerging market is how developed the stock market is. Index providers look at the things that make a market function ― how liquid the market is, how well-established the settlement and custodial systems are ― and then bucket them accordingly. It’s not at all about how rich or poor the people are. Q. What excites you about EM investing? A. It’s never boring. There are 25 countries in the EM index. They all have their own currency, unlike in Europe where many countries have the euro. All of these countries have their own economic cycle. There is also much more stock-level dispersion. All of this is great for an active investor. Q. What do people get wrong about EMs? A. Many people go in thinking they’ll capitalize on the old narrative that has the poorer country catching up with the rest of the world. That was EM investing 1.0. Today some EMs are leap-frogging DMs in areas of technology or entertainment, for example. Investors should be thinking about buying the potential to add alpha. When we look at emerging markets, we don’t see a great fairytale growth story. We just see a lot of potential for outperformance, and that’s what really excites us. Q. How many EM countries have you visited? A. I’ve visited roughly 35 emerging countries to date. I’m prouder to say that my three children, ages 10, 7 and 4, have visited 10.
1:1 with Gordon Fraser
Investing involves risk, including possible loss of principal. Stock values fluctuate in price so the value of your investment can go down depending on market conditions. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks may be heightened for investments in emerging markets. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of June 2020 and may change as subsequent conditions vary. The information and opinions contained herein are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. RO# 1205854. ©2020 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc. All other marks are the property of their respective owners. Prepared by BlackRock Investments, LLC, member FINRA. Not FDIC Insured • May Lose Value • No Bank Guarantee
Four stages of EM economic cycles
Source: BlackRock, as of May 2020. For illustrative purposes only; not meant to depict actual data. Country placement is based on BlackRock’s assessment and does not represent where countries may be in their actual economic cycles.
Historically, international investors have looked to emerging market (EM) equities for structural growth. This long-term growth case remains intact, but careful selection at country, sector, thematic and factor level will be more important than ever. Sonya Morris, managing director of Harbor Capital Advisors, said: ‘In our view, most investors can benefit from a long-term strategic allocation to emerging markets for reasons that most investors are already familiar with. EM stocks provide diversification from a variety of perspectives – country, industry and factor – exposing investors to a diversifying set of economic forces.’ Furthermore, favorable demographic trends, technological advances, improving levels of education and healthcare are some of the factors contributing to good stock returns as well as the ongoing advancement of developing economies on the global stage, she added. But for this asset class, it makes sense to go beyond beta, Morris believes. ‘We think investors can best benefit from emerging markets exposure by favoring active strategies over passive ones. Given the inefficiencies in the asset class, active managers stand a better chance of managing risks while providing better returns than index funds in our view,’ she said. There are a number of reasons for this, starting with risk, she said. ‘We think a passive strategy in emerging markets courts risks that some may not be fully aware of. One of the longstanding arguments for passive investing in any market is that it provides broadly diversified exposure and thus helps mitigate concentration risk. However, that argument is getting harder to make in emerging markets, as the diversification benefits of the MSCI EM index have declined significantly in recent years, largely because of the rise of China,’ she said.
As China’s economy has advanced and as MSCI has loosened benchmark restrictions on China-listed equities, the country’s representation in the index has steadily grown, and it now dominates the index,’ Morris said. ‘Just five years ago, China made up 23% of the index, but its allocation has climbed to more than 40% today. Furthermore, many of the other major countries in the index, such as South Korea and Taiwan, are significantly leveraged to the Chinese economy, perhaps compounding the influence of China on index performance.’ But the index has become increasingly top-heavy, Morris said. ‘The top five stocks now make up almost 20% of the index, with just two stocks – Alibaba and Tencent — accounting for 13%. Few investors would be comfortable with that much concentration in an active portfolio.’ Morris said active managers willing to deviate from the benchmark can provide better diversification and make the active calls necessary to avoid some of the idiosyncratic risks that come with emerging markets investing, such as more governmental control in economies and markets. ‘Furthermore, emerging markets have proven to be an alpha-rich environment for active strategies, unlike areas such as US large caps, where active managers have struggled to add value. Over the last 10 years, more than three quarters of the active managers in the Global Emerging Markets universe have outperformed the index. That compares to 40% of the active managers in the US Large Cap Core universe. Intuition said that less efficient asset classes should favor active management, and the data shows that has indeed been the case in emerging markets,’ she said.
Beyond going active in EM, Morris also thinks there is an argument to be made for favoring a value-oriented manager in the space. ‘The underperformance of value relative to growth has been a global phenomenon, but it has reached historic proportions in emerging markets. The performance difference between the two styles was amplified in Q1 partly due to the fact that the value universe has more of a cyclical tilt, exposing it to areas that were particularly hard hit in the pandemic-related selloff.’ But Harbor’s research shows that, while value has underperformed growth in EM recently, that hasn’t always been the case. ‘For the first part of this century, value outpaced growth in emerging markets; the MSCI EM Value index posted an 18% gain from January 1, 2001, through December 2010, compared to a 13% return for the MSCI EM Growth index,’ Morris said. ‘But the recent stretch of underperformance has opened up valuation opportunities for EM value stocks, as the EM Value index now trades at a meaningful discount to EM growth stocks as well as to its own 10-year history. So, for those seeking to add to their EM exposure, we think now could be an attractive entry point, particularly for value-oriented managers.’
Another lesson from the extreme volatility of the first quarter of 2020 is that specifics are highly important when it comes to EM investing, according to Collin McGee, an analyst at DiMeo-Schneider. He pointed out that while the March downturn was steep and fast, EMs held up better than most would presume. Comparing first quarter returns shows that emerging markets performed broadly in line with their developed counterparts: the MSCI EM and MSCI EAFE indices closed the quarter at -23.6% and -22.8%, respectively. ‘Given the higher historical volatility in emerging markets, this begs the question: Why wasn’t the recent downturn worse for them?’ he said. One vital factor was country-specific distinctions, and the way that these are reflected in the index weightings, he said. ‘If you look under the hood of the two indices, it’s clear that for emerging markets, key countries have a larger influence over broader outcomes. This is a consequence of the market capitalization construction methodology for the two indices,’ he said. ‘Within emerging markets, China comprises over 56% of the top 10 holdings, followed by Taiwan and South Korea. The MSCI EM index’s top 10 holdings comprise 26% of the total index’s weight, compared to 12% for EAFE. Further, the top 10 holdings in China make up almost 15% of the total index weight. Thus, returns of countries with a larger index representation are a much stronger force in emerging markets relative to developed.’ As a result, country level returns are highly influential in EMs, McGee said. For the first quarter of 2020, country returns were the largest performance driver – top/bottom return spreads were 38%. McGee said his firm assesses economic vitals at country level in emerging markets. ‘Our findings show larger countries as a percentage of the index have outperformed the smaller ones. This is partly due to smaller countries like Brazil and Mexico being significantly tied to oil exports and the negative impact on those countries from Opec’s decisions to increase oil production. Smaller countries in the index came into the crisis from a position of economic weakness relative to larger regions, with higher leverage as measured by government debt to GDP, lower foreign currency reserves and weak to negative GDP growth,’ he said.
Sector allocations have also had a significant effect on the downside experienced in EM because of the crisis, McGee said. ‘The “new normal” has driven outperformance in tech and healthcare sectors. This has had a profound effect in EM, as some of the largest names in the index are corporations within these sectors.’ DiMeo-Schneider sees EM as a widely inefficient asset class where, historically, active management has outperformed the index over the long run. ‘As a result of the crisis, we are seeing managers looking to add quality names to their portfolio with an eye on wish-list stocks that were previously at high valuations,’ McGee said. ‘As such, we expect active management to rebound as we work through the crisis and return to normalcy and believe investors should stick to their long-term strategic allocations,’ he said. Sector and thematic plays will become increasingly important as a way to invest in EM, said Carlos Gonzalez Lucar, head of manager research, RBC Wealth Management International. ‘Thirty years ago, investing in emerging markets consisted of just a handful of countries with accessible financial markets. Fast forward to today, and we now have more than 20 countries in the main emerging markets equity indices.’ In the past, EMs were seen as a cyclical play on the global economy or as a high-beta play on developed markets, he said. ‘By contrast, in the future, we will see less focus on emerging markets as isolated economies and more focus on sector/themes on a global scale, including emerging markets,’ he said. Gonzalez Lucar sees consumption and technology growth as the most likely drivers of long-term investment in emerging markets. ‘Continued urbanization, growth of the middle class and growing incomes are bringing about a rise in purchasing power and consumption. In China, for example, consumer sectors account for almost a quarter of the MSCI Emerging Markets index market cap (consumer discretionary 16% and consumer staples 7%). The pandemic has accelerated the shift to more online-based consumer activity, especially in Asia,’ he said. Technology today accounts for 17% of the EM index, compared to 20% for the MSCI World index, he said, and is expected to continue its growth trajectory due to scalability of business models, new developments and a world undergoing continued digitalization. ‘Investors tend to be under-allocated to China within global portfolios. To control the overall exposure to this market, investors can implement specific strategies geared towards domestically-listed equities, consumption sectors or smaller market cap companies, all of which may be more sensitive to China’s domestic growth,’ he said. China accounts for around 40% of the MSCI Emerging Markets index, having been only 0.5% in the mid-1990s, and this is a driver of the larger share of Asian countries in the index, he said.
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