By Darius McDermott, managing director of FundCalibre
It’s been a good run for emerging markets, but the dominant criticism has been that their success has come from just three stocks: semiconductor and memory giants TSMC, Samsung and SK Hynix. This has created volatility as the AI trade has wobbled. Yet the opportunity set remains far wider than this characterisation suggests. Active managers have started to pare back their exposure and are exploring other areas.
The contribution of these technology giants has been significant. TSMC’s share price is up 27% in the past 12 months, Samsung is up almost 90%. TSMC is now over 15% of the MSCI Emerging Markets index and technology is over 40%. However, their growth has not just come from raised expectations: they have also accounted for a significant chunk of the earnings growth in emerging markets.
More recently, however, they have brought volatility. The MSCI Emerging Markets index has fallen 14% over the past month alone as investors have reappraised the AI trade. Michael Bourke, manager of the M&G Global Emerging Markets fund, says: “The pressure has been most evident in the highly-owned technology-dominant North Asian markets [Taiwan, Korea], where investors questioned both the sustainability of capital expenditure and the returns available on increasingly-large infrastructure commitments.”
Many fund managers had already been selling down some of their holdings. Andrew Ness, manager of the Templeton Emerging Markets Investment Trust, says he has taken profits on the three names after a strong run. Jason Pidcock, manager of the Jupiter Asian Income fund, has also been moving to a more neutral position.
That said, Ness believes they still have a place in a portfolio. “The moats for businesses such as TSMC and Samsung Electronics have been built up over years and years of investment in research and development. That’s why these industries have concentrated and consolidated to just two or three players.”
Ness says there will still be cycles, but considers TSMC to be one of the world’s best businesses and, at around 20x earnings, attractively valued: “That’s still quite a compelling opportunity. With these companies, you own the toll road. You don’t care if it’s a Ferrari or a Mini Cooper driving on it because you make money either way. Whichever large language model is going through the architecture doesn’t matter to SK Hynix or Samsung or TSMC. Ultimately, it’s the fact that the toll road is being built.”
Diversification of earnings strength
However, Bourke believes investors need to pay attention to the diversification of earnings growth across emerging markets. “The sharp AI-fuelled IT earnings growth concentrated on South Korea and Taiwan masks the resilience elsewhere. Even China, for so long the bête noire of the emerging market equity world, is expected to deliver 14% higher earnings this year.
“The explanation for the earnings resilience is important. Emerging markets are not simply benefitting from a single technology trade. AI-related demand is supporting memory, foundry, equipment, power management and data centre supply chains, but the earnings recovery is also broadening into materials, financials, industrials and selected consumer businesses.”
Nick Robinson, head of the global emerging markets equity team at Aberdeen, which manages the abrdn Emerging Market Income Equity fund, agrees. He says there are four big capital spending trends from which emerging markets are benefitting, and AI is only one. He says: “There’s a supply chain and reshoring driver, which has changed in the last few years. It was previously about friendshoring, but it has become more subtle.
“Rising defence spending is also feeding through to emerging market defence companies, including Eastern European and Korean defence companies. There is the build-out of energy and grid infrastructure. Emerging markets have the largest copper producers on the planet, and also the bulk of the uranium producers. These are really important companies in infrastructure and energy. Yes, AI is big – but it’s not the only story.”
Bourke is also backing the banking sector. The banks are likely to be beneficiaries of continued, high economic activity, with “robust margins, improving credit quality and structurally-better balance sheets than in previous cycles”. There should be greater demand for lending as businesses expand, and banks are also longer-term winners from growing financial inclusion and broadening wealth.
Ness has a number of holdings in Brazil, even after the recent stockmarket rout in response to the re-election of left-leaning President Luiz Inácio Lula da Silva. “Brazilian corporates, and the banks in particular, have some of the best management teams globally. They’ve had to be good because they’ve operated in such a chaotic economic environment.”
Brazil has been so used to political disappointment and policy volatility that it’s not an immediate reason to exit, he says. He believes there is a self-correcting mechanism: “If the new administration pursues things that the markets think are unsustainable, then we’ll see a response in both the treasury yield curve and the currency, and things will change as they’ve done in the past.”
He is investing in a number of private sector banks and a financial services platform.
For Bourke, diversification matters: “It provides opportunity for us as active investors to become less dependent on a continuation of ever-higher valuations for a narrow group of semiconductor companies. We favour diversification across the asset class rather than the herding into IT/AI names.”
Ness believes it is a reminder that, “these aren’t your granny’s emerging markets.” The sector has fundamentally changed over the past 25 years. “It is almost unrecognisable from the one I started in.”
Just as the image of emerging markets as a set of natural resources, brewing companies and banks looks dated, so does the idea that it is dependent on a handful of AI giants. Emerging markets provide a rich opportunity set.
