Seize the emerging opportunities

Investing in emerging markets is a healthy combination of a positive long-term outlook with benefits in the short-term (Photo : Capital Group)

Investing in emerging markets is a healthy combination of a positive long-term outlook with benefits in the short-term (Photo : Capital Group)

Investing in emerging markets is a healthy combination of a positive long-term outlook with benefits in the short-term. With changing opportunity sets, cyclical recovery and structural growth sectors, there are a lot of possibilities for investment. Emerging markets funds investment specialist Valeria Vine takes an in depth look at the future of emerging markets. 

How is Capital Group approach to emerging markets distinctive?

35 years ago, when we launched our first global emerging market equity fund, we were among the first to conduct research on the ground. Our analysts and portfolio managers have established relationships with the suppliers, managers, and customers of various companies. In our research portfolio, we have analysts that not only make recommendations but also manage around 20% of the portfolio. The tenure of our analysts is about 15 years of experience, which is much higher than the industry average. We use the unique so-called Capital SystemSM to manage our funds. We have multiple portfolio managers in each fund with differing investment approaches and outlooks on the investment landscape. The result is a portfolio that is of high conviction, well diversified and balanced, which reduces the risk for our clients.

What is the outlook for emerging markets in 2021 and beyond?

In 2020, there are numerous high growth sectors, such as e-commerce, gaming and health care, all growing rapidly in the MSCI Emerging Market index. These industries have done very well in the US market: they were less than 30% of the index ten years ago and today they represent over half. Changing structures and opportunity sets are long-term drivers in emerging markets. But why invest now? Considering the short-term, we are in a period of cyclical recovery and this period is generally very good for emerging markets. It doesn’t have to mean investing into energy or materials, you could just invest more into cyclically exposed economies and really take advantage of the recovery that we are experiencing now. Travel and tourism have suffered immensely, yet whenever there is a shock, the industry tends to recover quite quickly. 

Is there a different outlook for emerging market equities than for emerging markets debt?

With the global search for yield, there are very good opportunities for returns in both equity and debt. There are two key areas within equities: companies benefitting from cyclical recovery and from tourism recovery, and the structural growth sectors such as healthcare, payments, e-commerce, and gaming that were growing fast anyway, but the pandemic has provided a huge boost.

The opportunity set is much larger on the debt side. A number of countries don’t have equity markets but are growing rapidly and there are credit improvements. Take tourism: you could invest in hotels, online travel agencies or aircraft manufacture, or bonds in the Dominican Republic. Before the pandemic, it was one of the fastest growing countries in the world and the economy is quite diversified for a Caribbean nation. The spread over treasury is about 3-3.5% and the local currency yields are between 7-8%. These are yields you would struggle to find in developed markets. The additional benefit of places like the Dominican Republic, African insurers, or Ukraine is that there is less correlation with what’s happening in India and with the trade tensions between China and US. Emerging markets currencies are currently undervalued after many years of dollar strength, which can present additional opportunities in the local currency part of the emerging markets debt universe. 

Emerging markets debt would naturally be more susceptible to any rise in interest rates. We’ve seen this to an extent during the first quarter of 2021, where just the expectation of rising interest created significant volatility. Emerging markets debt is now under-owned by foreign investors which is a mitigating factor for any potential volatility that could result. 

Is there an emerging market segment that would give better results: country, sector, etc.?

There is a lot of potential for credit improvement, particularly within cyclically exposed economies, local currency debt and high yielding debt. For high yielding debt, you have to be very selective due to the deterioration of fundamentals in a few countries following the pandemic. If we look at the tech sector in emerging markets, a number of companies such as Alibaba, Samsung and so on are based in Taiwan, China and Korea. When there is a regulatory oversight increase, or a tension in China, these companies are quite correlated and because they are such a large portion of the index the volatility can be higher. Alibaba was 8% of the entire MSCI Emerging Markets Index at some point in 2020, for instance. Being mindful of these exposures is essential. If something falls 50% it has to rise 100% just to return to where it was. In addition to keeping in mind that emerging markets may suffer from liquidity problems, managing drawdowns can be helpful particularly for clients that don’t have the appetite for this kind of volatility, and combining assets is necessary to diversify exposure and balance volatility.

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