Investment Opportunities – Emerging markets

A decade ago emerging markets were many commentators’ hot tip. Emerging markets have been slow to realise these ambitions, and have suffered from negative sentiment over the last few years. There are four key emerging markets which make up the acronym BRIC – Brazil, Russia, India and China. There are opportunities for investors in these emerging markets and we set out the investment case below.

Key points:

  • Drivers of global growth going forward
  • Positive demographics
  • 80% of the world’s population
  • Less efficient, attractive valuations
  • Good levels of income
  • Diversification

What makes a country an emerging market?

Emerging markets (EM) are poor, underdeveloped countries whose economies are experiencing rapid economic and household income growth in tandem with industrialisation. They differ from their developed market (DM) counterparts in four key ways:

  • Low household incomes
  • Undergoing structural changes e.g. modernisation of infrastructure or moving from an agriculture to a manufacturing-based economy
  • Economic development and reform programmes underway
  • Less mature stock markets

Emerging market share of global GDP is now more than 50%

These countries account for more than 80% of the world’s population and close to 60% of global economic output (GDP), as you can see from the chart to the right. You can get a clear sense of the difference between developed and emerging markets from the table below, where you can see the huge populations of China and India in particular, but the relatively low GDP per capita (income per person) for emerging nations. China underlined its global importance when the yuan was added to the IMF’s basket of reserve currencies in October 2016 alongside the US dollar, sterling, euro and yen.

Economic comparison of Developed and BRIC countries

Country Population (Mil) Over 65, % Share of World Population, % Annual GDP (Bil,$) GDP,YoY % Share of World GDP, % GDP per capita, $ (Income per person)
World 7,374.8 8.7 73.434 2.9
Developed UK 64.4 17.9 0.9 2,849 2.2 3.9 44,239
US 324.0 15.3 4.4 17,947 1.2 24.4 55,392
Japan 126.7 27.3 1.7 4,123 0.8 5.6 32,541
Eurozone 407.8 17.5 5.5 11,540 1.6 15.7 28,298
B Brazil 205.8 8.1 2.8 1,175 -3.8 1.6 5,709
R Russia 142.4 13.9 1.9 1,326 -0.6 1.8 9,312
I India 1266.9 6.1 17.2 2,074 5.3 2.8 1,637
C China 1373.5 10.3 18.6 10,866 6.7 14.8 7,911
Source: Bloomberg

The investment case

While few experts are predicting a raging bull market for emerging markets, there are signs that some of the negative sentiment has become exaggerated. Stocks remain cheap relative to their developed market counterparts, and fund managers and economists are more upbeat on the prospects for emerging markets. It’s also important to remember emerging markets is a diverse asset class with many different country stories, and the transition in emerging economies is not yet complete. So what’s in it for investors?

Exposure to emerging markets can benefit your portfolio in two ways; as well as giving access to the exciting growing opportunities in these markets it can also add further diversification for investors who may be concentrated in their home territory or markets dominated by more mature economies. As emerging markets’ share of global GDP continue to increase they become increasingly important and ever more difficult to ignore as an investor. However you should be mindful that investing in emerging markets also carries higher risks and volatility. The value of emerging market investments may be affected by currency fluctuation which might reduce their value in sterling. Indeed, currency rates can have a significant impact, both positive and negative, on the returns from emerging markets. Over the last quarter for example, sterling investors in emerging markets would have benefited from the weakness of the pound.

Emerging market countries often have less stable political systems and less stringent regulatory controls and corporate governance. While investors can get higher returns as emerging markets are less efficient, you should be aware that conventional indices which track emerging markets can be highly concentrated geographically and by sector; for example the MSCI Emerging Markets index is heavily skewed to China, South Korea and Taiwan, and in sector terms have large weightings in financials and information technology. This is a great example of the developing process where the stock markets of some of these countries do not reflect their underlying economic activity. Russia and Brazil, for example, have small weightings in the MSCI EM index.

Source: BlackRock

Emerging markets performance

Emerging markets have been out of favour with many investors in recent years. Fears about China’s growth slowing down, possible destabilisation of the renminbi and the knock on effect to the rest of the world caused most investors to shun these markets. Due largely to China’s slowdown and slow growth in the rest of the world, other emerging markets have been held back by a mix of weak commodity prices, sluggish export growth and political disruptions. The economic growth in these markets is not always reflected in stock market prices; we have seen significant underperformance of the MSCI Emerging Markets Equity index relative to developed market indices over the last five years. More recently, however, this trend has reversed, with emerging market equities rallying almost 30% this year. Earnings growth for the MSCI Emerging Markets index is 2.0% year-to-date (to the end of September) compared with -0.6% for the MSCI World index, which measures developed markets. The P/E ratio of the emerging markets index is also more attractive, at 15 versus 23 for developed markets. Emerging market companies have also largely been immune to events such as Brexit.

Fund flows in and out of emerging markets

  • Funds in many sectors have suffered net outflows this year
  • Global emerging market equity and bond funds have seen a good level of inflows
  • The global emerging market equity sector has grown its market share by 1.4% year-to-date (to end of August), and global emerging market bonds has grown its market share by 5.6%
  • Quarter-to-date, which coincides with the fallout of the UK’s Brexit decision, the growth has been even higher, at 2.0 and 8.4% respectively
  • Global emerging market equities have had net inflows of £183m this year, with £117m going into global emerging market bonds

Global emerging markets funds

As mentioned earlier, emerging markets is not one homogenous area but comprises many different countries all with their own attributes and attractions. A good way to access emerging markets as a whole is via global emerging markets funds such as Fidelity Emerging Markets and M&G Global Emerging Markets.

The Fidelity fund, managed by Nick Price, seeks out quality growth companies which can fund their own growth without relying on excessive debt or acquisitions. Price says there is a rotation of investors back into emerging markets where there will be gains, albeit diluted. "We’re seeing renewed enthusiasm for emerging market equities selectively."

The M&G fund, by comparison, has a strong focus on corporate governance and shareholder value creation. Manager Matthew Vaight has a value bias, looking for out-of-favour companies.

"For us, the changes taking place at the company level are the most exciting aspect of the emerging markets story," says Vaight. "We consider the improvement in corporate culture and the emergence of world class businesses to be compelling reasons to invest in emerging markets today."

For exposure to just the Asian area of emerging markets, Veritas Asian is on our Recommended Funds list. Experienced manager Ezra Sun focuses on two factors which he believes are the drivers of strong returns – dividend yield and earnings momentum.

Source: Morningstar

Source: Morningstar

Emerging markets for income

Source: Morningstar

The case for income from emerging market equities is a strong one. The JPM Emerging Markets Income fund invests in Taiwan, for example, where historically there have been plenty of companies paying good, stable dividends. The fund also has holdings in South Africa, where listed companies typically have high returns on capital, strong management and healthy dividend payouts. China also offers income opportunities on a stock specific basis; it too has a history of companies adopting positive dividend policies. In many cases emerging market companies have continued to pay dividends even in tough times. Portfolio manager Omar Negyal says: "When it comes to emerging markets, the presence of a dividend stream can go some way to softening the risk profile for investors."

Schroder Asian Income focuses on the Asian income story. These are markets which are still developing, and tend to be inefficient because many Asian investors are traders. Skilled long-term fund managers are able to find growth companies with attractive yields. At the same time there is a fundamental shift in the corporate culture, with companies starting to think differently about returning assets to shareholders.

Emerging market debt

Don’t forget you can also access emerging markets via emerging market debt funds. The breadth and depth of fixed income investments has grown over time and emerging market debt has become a viable asset class in its own right. The asset class has grown to $14.8 trillion (£11.3 trillion), with more than 1000 sovereign and corporate issuers based in 80 countries. 66% of current issues are now rated as investment grade, so there is no lack of quality.

The current environment of low interest rates combined with uncertainty over the prospects for bonds in the developed world have made it difficult for many investors to find a good level of income. Emerging market debt has not only delivered strong returns over the last five years, but again the income story is compelling. Yields continue to be attractive: emerging market spreads have widened sharply and the yield on the JPM Global index is now more than 5% compared to 0.88% on a 10 year UK gilt.

Pictet-Global Emerging Debt is highly diversified, investing in a broad range of emerging market bonds. The fund is actively managed using a combination of a top-down and bottom-up approach, assessing both the global environment and country specific analysis. "Overall, a yield of over 6% on a government bond asset class remains attractive," says fund manager Simon Lue-Fong. "A market with over 65 countries represents a wide opportunity set, and expectations of reduced bond issuance and few attractive alternatives are supportive factors." This offers some great opportunities for yield, which have been hard to come by from many asset classes.

 

Emerging markets acronyms

  • The investment world loves a good acronym. The original emerging markets acronym, BRICs (Brazil, Russia, India & China), was coined in 2001 by Jim O’Neill, an economist at Goldman Sachs.
  • This was followed by others including MINT (Mexico, Indonesia, Nigeria & Turkey), which are the next tier of large emerging economies to follow the BRICs, and BIITS (Brazil, Indonesia, India, Turkey & South Africa), also known as the 'Fragile Five', which are the economies most vulnerable to a US Federal Reserve tightening of monetary policy.
  • Other acronyms include CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey & South Africa), which were supposed to drive growth from 2010 to 2020, and
  • EAGLEs (Emerging And Growth Leading Economies), which has its members updated regularly.
  • The 'Next 11' is also regularly referred to, being the countries identified as having the potential to become among the world’s largest economies this century and comprising Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, Turkey, South Korea & Vietnam.

India – the “biggest turnaround story” in EM

If you want to go further and pick out a particular country in which to invest, India, one of the two major emerging market economies alongside China, has been called the “biggest turnaround story” in emerging markets. The Indian government has a strong focus on long-term, gradual GDP growth. A number of successful reforms have contributed to this growth, including increased infrastructure spending, reforms in the power sector and streamlining the country’s much maligned bureaucracy. India’s demographics are also helping. Its population is young and growing, leading to more output and more demand, and the country has an ever growing middle class with plenty of spending power.

Customers wanting to invest directly in India could look at Jupiter India, which is already a popular fund on the TD Direct Investing platform. The fund aims to identify under-researched companies with strong growth prospects and has delivered strong long-term performance.

This emerging consumer in India, China and other emerging market nations is contributing strongly to the global demand for goods and services, in particular premium products. Funds such as JB Luxury Brands, which invests in companies in the high growth luxury brands sector, have benefited hugely from this trend.

You can also access emerging markets via exchange traded funds (ETFs), which enable you to buy an entire emerging market index. We would highlight iShares Emerging Markets Dividend UCITS ETF (GBP) SEDY, SPDR® MSCI Emerging Markets UCITS ETF (GBP) EMRG and iShares J.P. Morgan $ Emerging Markets Bond UCITS ETF (GBP) SEMB as good ways of gaining broad emerging market exposure.

At a country level Lyxor UCITS ETF MSCI India C-USD (GBP) INRL offers access to the Indian market.

For more information on the emerging market funds in our Recommended Funds list click here and use our Fund Selector to search within each asset class.

Exchange Traded Funds track a wide variety of underlying investments, some of which may be complex in nature and involve leverage, shorting or a high degree of volatility. It is therefore important that you read the Prospectus or Fact Sheet (available on the issuers’ websites) prior to investing and ensure that you understand how it is structured and the associated risks.

Investing in Emerging Market Investments involve different risks from the UK markets, in many cases the risks are greater.

The value of international investments are affected by currency fluctuations which might reduce their value in sterling.

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