10 May 2022
In his hit song “Walls”, Tom Petty sang, "Some days are diamonds, some days are rocks." Although he wasn't singing about emerging markets, this unwittingly sums up the asset class - inherently cyclical in nature. Over the past few months, emerging markets have been a case of all risk and no return. My recent trip to visit with US investors confirms that this view is on the minds of allocators and consultants from coast to coast. Being back on US soil following a COVID-induced hiatus was a pleasure, to meet with colleagues and clients in person and importantly to debate and discuss views on markets. The following is a summary of the key topics that were discussed during my meetings.
Globalization has been a dominant theme over the past four decades and a key driver of corporate earnings and returns. It has led to companies a. adopting asset-light business models, favoring just-in-time inventory management (which has boosted asset turns), b. outsourcing business processes (which has boosted profit margins), and c. increasing leverage to buy back shares (which has boosted earnings per share). However, three supply shocks over the past four years - US/China trade war, COVID, Russia/Ukraine - have exposed the frailties in these integrated supply chains. In fact, companies are now shifting focus to just-in-case inventory management, localization, and vertical integration to shore up supply – essentially, deglobalization. For example, China power-tool company Techtronics Industries* recently declared that 25% of production will shift to the US by 2024. The culmination of these acute supply shocks and the trend towards deglobalization is ultimately inflationary. It is also likely to mean that higher costs are here to stay for longer. We think that operating in a deglobalizing world requires a nuanced, flexible approach to generating alpha in EM.
These nuances are expressed in our portfolios through three broad buckets:
China’s risks can broadly be summarized as:
While these risks are tangible and cannot be underplayed, we would counter that the steer from China's Vice Premier Liu He on March 14, 2022, is incrementally positive. Acknowledging that the economy is under pressure, he expressed the importance of using monetary policy to stimulate the economy, that any further regulation would be balanced by introducing market-friendly policies to support businesses, and finally that China would be willing to take the first step in revealing the financial accounts of US-listed Chinese firms to the SEC. It is also our view that given the events around Russia's invasion and the severe repercussions, the risk of China stepping outside of its borders has decreased at the current moment (although not disappeared).
EM ex-China is an asset class that has attracted more attention in recent years. Investing in China has polarized opinions, which has led to some China bulls to opt for a discrete China allocation versus some China bears who wish to strip China out of the equation. This phenomenon has supported the viability of the EM ex-China asset class.
Importantly, we feel that the quality of the opportunity set is not compromised by removing China. Compared to emerging markets, Asia and Consumer Discretionary are down-weighted vs. Latin America and Information Technology that are up-weighted. Key markets such as Taiwan, Korea and India are up-weighted, which is a fertile hunting ground for consumer technology businesses, whereas the likes of Brazil and Mexico provide access to some of the world’s leading commodities companies. For more detail on the investable universe and our portfolio, read our latest update here.
The asset class is trading at a ~40% discount compared to developed markets, not far off from 20-year lows. With the asset class broadly under-owned, investor sentiment at the point of “Is China investible?”, and a prolonged period of relative underperformance, we believe the asset class provides an attractive long-term opportunity for investors.
Notably, the asset class has come on in leaps and bounds over the past decade. One only needs to look at the top 20 benchmark names to evidence this. An index previously dominated by clunky state-owned companies has given way to enterprising, founder-led businesses with stronger governance norms. We believe that this a function of a distinct change in attitudes in emerging markets over the years that celebrates and promotes entrepreneurship. Using the blueprint of successful Western entrepreneurs, emerging markets have their own breed of game-changing founders, such as Chinese EV battery manufacturer CATL's Robin Zeng, Indian conglomerate Reliance Industries' Mukesh Ambani, and Internet giant Tencent’s Pony Ma, to name a few.
To summarize emerging markets in a nutshell: a more attractive opportunity set, a long growth runway, a supportive environment for entrepreneurs, and bargain basement valuations that appear to be pricing in a lot of the risks.
I look forward to more conversations on emerging markets…but for now, “I’m leaving on a jet plane…” and do look forward to being back again.
Portfolio Manager, EME ex-China, 4Factor
*This stock is held in 4Factor portfolios.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.