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Emerging markets deliver on their potential

Nicki Bourlioufas  |  30 Nov 2020Text size  Decrease  Increase  |  
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Despite the economic hit from COVID-19, equities in many emerging markets have rallied to match and even exceed pre-pandemic levels. Much of the outperformance is due to their higher economic growth and, in some cases, superior handling of the COVID-19 pandemic, asset managers say.

Following the COVID-19 sell-off in March 2020, central banks in emerging markets cut interest rates to combat sharp currency depreciations and massive capital outflows. This helped their economies to recover quickly from the pandemic. Moreover, the ability of east Asian nations to contain the pandemic has helped staunch the economic damage and promote a recovery, asset managers stay.

“By taking interest rates towards zero, a number of emerging market central banks have helped to enable their economies to function close to normality,” said Ron Leven, Professor of Economics at Duke University in a recent research piece, COVID-19: Are emerging markets recovering?

“Emerging market equities are outperforming the general developed markets—even including US equities. Within the developed markets, Japan has paralleled the US gains but Europe, and (perhaps reflexing the looming Brexit) especially the UK, have badly lagged,” he says.

“While the leading performance of the Asian markets can, in part, be attributed to the fading of COVID-19, this is clearly not the whole story … Many emerging economies have also benefited by their central banks now following the lead of the developed world in taking rates towards zero,” says Leven.

a picture of a woman walking in Japan wearing a face mask

The ability of east Asian nations to contain the pandemic has helped staunch the economic damage and promote a recovery, asset managers say

Technology too, has had a role to play, says Laird Abernethy, managing director of Australia and NZ at GQG Partners, a boutique global equities investment firm. Emerging markets offer unique investment opportunities, says Abernethy.

Historically, emerging markets have been much more susceptible to volatile commodity cycles and cyclical swings compared to domestic markets. However, in recent years, this has diminished as technology companies, especially in Asian emerging markets, now account for a greater proportion of the share market—and many tech players have rallied since COVID-19.

“People associate emerging markets with being very cyclical, since many of them were commodity-based years ago.  This would tie them very closely to the economic cycle,” says Abernethy. “Many of today’s technology companies, say for instance, e-commerce platforms and software companies, are far less volatile since they are beneficiaries of more secular trends.”   

Abernethy favours emerging markets as they allow investors direct access to a higher growth rate driven by the wealth effect taking place among a growing middle class. Conversely, the middle class in developed markets has stagnated. “Although many secular trends begin in developed markets they tend to expand faster to the upside when introduced to emerging markets,” says Abernethy.

Emerging market equity markets will likely remain a more volatile section of the global stock market, which may deter investors seeking more stable returns, according to Anthony Doyle, a cross-asset specialist at Fidelity International.

“If, however, investors have a long-time horizon and accept the higher volatility, then emerging market equities would be expected to pay returns well in excess of developed market equities in the coming decades,” says Doyle.

“For example, total annual returns in emerging market equities are expected to be 8.0 per cent on average in the coming decade according to Fidelity International’s Capital Market Assumptions. This compares to 6.8 per cent in developed market equities.

“For those able to lock up funds and accept the potential volatility, emerging market equities—and Asian equities in particular—may well make a strong addition to a portfolio, particularly given current valuations, says Doyle.  

He adds that short-term volatility can provide an opportunity for investors to establish or increase an allocation to emerging markets, says Doyle.

“At any point since 1987, an investor in Asian equities with an investment horizon of seven years or more has experienced a positive total return, highlighting the importance of looking through short-term market movements.

“In a world searching for growth, structural and cyclical forces are combining to highlight the attractiveness of Asia as a destination for investment. China has been the undoubted star of the region, given its sheer size and growth trajectory, while other parts of Asia have registered equally impressive gains.

“By 2023, it is estimated that the economies of emerging and developing Asia will be larger than all the advanced economies combined … Secular growth trends within the Asian millennial generation indicate that the region will be an attractive source of investment returns for years to come. The region is simply too large to ignore for Australian investors.” 

Mixed performances

Perhaps in part due to the growth of technology, Asian emerging markets have led gains and recovered more quickly than many others during the COVID-19 pandemic. Latin American markets have been mixed while Emerging Europe, Middle East and African nations, except South Africa, have fared poorly.

China, in particular, “was both extremely aggressive in its early response to the virus and is now seeing the benefits of this with almost no reported new cases and near-full resumption of normal economic activity,” says Leven.

But across the board, emerging markets have survived the pandemic relatively well due to their lowering of interest rates, says the Reserve Bank of Australia in a new research paper.

“Emerging nations have dropped official interest rates in sharp contrast to the Asian Financial Crisis and some more recent periods when emerging markets interest rates were generally increased at times of tightening financial conditions for emerging markets in order to limit capital outlooks,” the RBA says.

This time around, “emerging market central banks intervened extensively in the foreign exchange market during the most acute phase of the COVID-19 crisis to support their currencies. These interventions dampened financial stability risks that can arise from sudden increases in the value of foreign currency obligations.”

Managed funds cover the region

In terms of investment options, the Morningstar gold-rated Capital Group New World Fund focuses on capturing the long-term growth potential of developing economies. It provides exposure to developing markets by investing in leading emerging market companies as well as multinational companies with significant exposure to the developing world. The fund’s top 10 holdings include Facebook and Microsoft, which have helped spur on a strong outperformance, as well as leading Chinese technology companies Alibaba and Tencent.

Morningstar senior analyst Christopher Franz says including companies from developed countries, such as Microsoft and Facebook, “dampens the volatility profile of the fund and it gives investors a smoother ride.” The companies drive at least 20 per cent of their revenue from emerging markets, while the fund itself must have at least 35 per cent of its assets invested in companies listed in emerging nations.

The gold-rated Robeco Emerging Conservative Equities invests in low-volatility stocks in emerging countries globally, based on a quantitative model. The fund's long-term aim is to achieve returns equal to, or greater than, those on emerging equity markets with lower expected downside risk.

According to Morningstar analyst Simon Scott, Robeco’s “talented team, well-defined process and reliable performance pattern make this an appealing offering for investors.”

The fund tends to lag during strong bull markets yet outperform during volatile environments.  “The time-tested quant model mainly seeks low-risk stocks, as measured by their volatility and distress metrics, but valuation and momentum factors are also incorporated,” says Scott. 

According to Morningstar’s Franz, both exchange-traded funds and actively managed funds can offer good exposure to emerging markets, though given the scope for outperformance due to the wide investment universe, active managers can potentially leverage this to the benefit of investors.

“Active managers can go anywhere in emerging markets, but if they are charging a much higher fee than ETFs, then that’s not going to be beneficial for investors,” Franz says.

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

See also Morningstar Guide to International Investing.

 

 

 

 

 

 

 

is a Morningstar contributor.

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