Darius McDermott: Four routes to tap into an emerging market rebound

There is an element of investors having to roll with the punches, says FundCalibre MD

I'm MD of Chelsea Financial Services and FundCalibre.com
Darius McDermott

“Sometimes you just have to cut out the noise and try to focus on what you think the market is not thinking about.”

The above quote was the one which stuck in my mind following a recent interview with a fund manager when discussing global equities. With uncertainty on inflation, recession and no potential style-bias in markets at the moment – quite frankly, there is an element of investors having to roll with the punches and expect the unexpected.

Emerging market underperformance

Emerging market investors would tell you they have been ducking and weaving those punches for a long time. Since the end of the commodity super-cycle, the economic growth premium – or differential – of emerging markets over developed markets has slowed. The rise of growth investing, and a few tech behemoths, has also hit the region hard.

Since March 2009 (when markets bottomed following the Global Financial Crisis) the MSCI Emerging Markets index has returned less than half the returns produced by global developed market equities (477% versus 208%, according to FE).

Last year saw emerging markets face more than their fair share of challenges. Among them were Russia’s invasion of Ukraine, tighter financial conditions to combat higher inflation, a stronger US dollar, and China’s economic growth decline due to its zero-Covid policy and property sector woes.

See also: – Darius McDermott: Four ways to invest in Japan in 2023 

However, the final quarter of 2022 did see some green shoots as China re-opened, the dollar weakened, and inflation slowed. This, coupled with some of the longer-term trends – favourable demographics, manufacturing capabilities, the rising middle classes and growing infrastructure needs (both from a supply and demand side) – meant many were expecting a bounce back from emerging markets equities in 2023.

Year-to-date, MSCI Emerging Markets have recorded a slight loss, although that is largely due to a tough February when markets fell on the expectation that rates would rise due to stickier inflation. The China re-opening rally lost steam and was exacerbated by re-escalation in US-China tensions. However, I do believe there are now several potential catalysts in favour of emerging markets over the long-term – provided investors can take the rough with the smooth.

Numerous short- to medium-term catalysts to consider

Despite concerns being raised last month, the wider consensus expectation is we will see a decrease in US inflation in 2023, as supply bottlenecks ease and growth declines. Franklin Templeton chief investment officer for emerging markets equities Manraj Sekhon said with peak inflation behind us, investors can focus on the implications of a change in the pace of US Federal Reserve rate hikes.

He commented: “These include a weaker US dollar and a reduction in the equity risk premium, both of which are positive for emerging markets. A recovery in emerging market fund flows will likely accompany a weaker US dollar, as investors turn to higher growth markets.”

China’s challenges are well-documented with its Covid-zero policy and the overhanging threat of government intervention – as well as ongoing geopolitical wrangling with the US. But the re-opening play/pivot by the government in late October has now seen the market rally almost 30%, and it was up almost 50% until late January 2023. Returns are unlikely to be smooth, but the wider view is that growth estimates will begin to rise from their modest levels – as will demand.

But the region is clearly much more than a China play these days. India, for example, is now one of the world’s largest economies. Indeed, while China was down almost 12% in relative performance versus the MSCI World for the first eleven months of 2022, the likes of Chile, Brazil, Indonesia, Mexico, South Africa and India all outperformed the MSCI World on a relative basis by double digits over the same timeframe.

While geopolitics are an issue for China, it can also benefit other emerging economies – indicating that globalisation is alive and well. Morgan Stanley chief investment officer, wealth management, Lisa Shallett said the reorganisation of strategic supply chains could create new opportunities for other emerging market nations in areas such as consumer and industrial goods. For example, Apple is moving its iPhone production to India – which will account for up to 50 per cent of its manufacture by 2027.

Growth is also likely to be aided by the move to net zero. Moving to a world of secure energy puts significant pressure on production of certain commodities, many of which are concentrated in a handful of countries in emerging markets. Last, but not least, is valuations – which have been trading at a 35% discount to developed markets on price/earnings terms.

Below are four routes we’d consider for emerging markets exposure:

The China play

From a pure valuation perspective, Chinese equities are still cheap post the re-opening. We must also remember it is the second biggest economy in the world. The FSSA Greater China Growth Fund is a good starting point, having consistently performed over a long period. The fund focuses on individual company research, with manager Martin Lau investing in quality companies with barriers to entry, pricing power and sustainable growth. Governance is a very important element of the fund, although the manager does look at state owned enterprises where this is improving. The final portfolio typically consists of 50-60 stocks.

The safer income option – without China

We have seen the Chinese government flex its muscles by interfering before and we should not be surprised if it interferes again, so I’d also consider a product without any Chinese exposure – the fact it offers an attractive income is a bonus. The Jupiter Asian Income Fund manager Jason Pidcock cited political concerns as the main reason for not investing in China. He sold his last remaining mainland China stocks, as well as one Macau-based business, in July 2022, but had been underweight China for some time, due to his low expectations of corporate profitability relative to the rest of the region.

The fund aims to yield 20% more than the respective benchmark and is typically high conviction with between 30-50 stocks held. The focus on large companies with reliable returns, makes it an attractive defensive Asia Pacific option.

The solid all-rounder

GQG Partners Emerging Markets Equity targets 200-300 basis points annualised outperformance over a full market cycle with less volatility. We like the manager’s philosophy of building a concentrated high-quality portfolio with durable earnings. The emphasis is on future quality, rather than companies which have simply done well historically.

Small and mid-caps for long-term reward

Regardless of sector, we’ve always felt as a team that small and mid-caps are the place to be if you want to drive long-term returns. The small and mid-cap opportunities in emerging markets are enormous, but also carry significant risk. So, we would look for a fund we feel is competent in managing those pitfalls. Federated Hermes Global Emerging Markets SMID Equity targets a high single-digit return per annum over the longer-term of five-10 years. Manager Kunjal Gala looks for quality companies that are exhibiting compound growth and that earn more than their cost of capital over the long-term.



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