Actively navigating EM equities
Varun Laijawalla believes an active approach is imperative to investing in emerging markets, which he illustrates by relating to his team’s experiences of investing in two EM powerhouses – India and China.
19 minutes
Key takeaways
- Repeated supply shocks are testing policymakers and making developed market bonds behave badly. In contrast, emerging market (EM) debt is showing greater resilience, reflecting stronger policy frameworks and healthier external balances, among other factors.
- The Middle East is a case in point: the market reaction to the outbreak of war in Iran proved short-lived, reflecting a macro transformation as the region reduces its reliance on oil and deepens its capital markets.
- Inflation risks remain, but EM central banks appear relatively well placed. Since the conflict began, EM inflation expectations have risen by only about 50 basis points, while high real rates provide room to respond.
- For investors, the EM opportunity set is widening. Falling renewable energy costs are creating new private credit opportunities, often linked to heavy-asset, low-obsolescence businesses.
- In equities, a number of EM companies are well placed to benefit from global AI developments and these still offer compelling valuations.
- Across the EM universe, country-specific concerns often overshadow a company’s underlying fundamental strength, pushing yields above those offered by DM bonds of a similar credit quality. This phenomenon extends to the private market space, where the reason for the favourable risk/return profile is an enduring barrier to entry.
- With supply shocks becoming the new norm, traditional asset class behaviour shifting and old EM/DM distinctions breaking down, investors must rethink how they build resilience and diversification in their portfolios while positioning themselves for a transforming world.
Market reactions paint a picture of EM resilience
Conflict-related commodity market disruption is just the latest in a series of shocks testing policymakers and unsettling investors. Yet a familiar pattern is playing out in markets.
Historically, emerging markets (EMs) have borne the brunt of supply shocks, but in recent years resilience has become a common theme. From the post-COVID energy/inflation shock to last year’s trade tariffs and now war in Iran, the initial EM sell-off has been brief and EM outperformance has ensued.
At the same time, developed markets (DMs) have faced rising yields and higher volatility, blurring the traditional distinction between EM and DM risk. Behind this lies relative strengthening in EM, with prudent fiscal policy, healthier current accounts and proactive central banks all boosting resilience. Investors and rating agencies are increasingly recognising these improvements, with the current EM upgrade cycle among the strongest seen in recent decades.
Better placed to withstand inflation headwinds
Looking ahead, the key question is whether renewed supply shocks could trigger another inflationary episode similar to 2022, when inflation peaked at around 10% in EM1 and 7% in DM.
There will be winners and losers, but the backdrop is very different to 2022 when inflation forecasts had already risen sharply before Russia invaded Ukraine. Since February, EM inflation expectations have only increased by c.50bps and while a further rise is likely, high real rates across EM give central bank policymakers a lot more flexibility than their DM counterparts.
That resilience is also visible at the corporate level, where many EM companies are accustomed to operating with higher rates and inflation than their developed market peers. Coupled with the strong activity data seen across much of the EM universe, that means that EM economies should be better placed to deal with inflationary pressures arising from the supply shock vis-à-vis their DM counterparts.
Broader lessons from the Middle East
The market reaction to war in Iran is also informative through a more regional lens. While Middle Eastern markets initially came under pressure, the reaction proved short-lived. Credit spreads have already fallen back to pre-war levels, credit ratings have been largely unscathed and ongoing bond issuance is receiving strong investor demand.
The resilience seen in Middle Eastern markets reflects a macroeconomic transformation: many economies have worked hard to reduce their reliance on oil exports and that’s really paying off.
The region is also benefiting from efforts to position itself as a strategic commercial and financial hub in an increasingly multipolar world. There are distinct parallels with the City of London in the early 2000s: authorities have made it abundantly clear that the region is open for business, and the number of global companies establishing a presence there is rising. At the same time, the region’s bond markets are becoming bigger, broader and deeper.
Alongside economic reform, the region is also undergoing rapid social and cultural change. From the vibrant social scene in an increasingly multicultural Saudi Arabia to plans for the region’s first casino in the UAE, the Middle East is changing and fast. Coupled with a raft of favourable characteristics – from time zone to connectivity – this is one of the most exciting regions for investors today.
Energy market dynamics – a structural growth story for EM investors
While the oil price shock is a global challenge, energy market dynamics are also providing a rich EM-centric opportunity set for investors. Rising energy demand is coinciding with constrained and disrupted supply. Crucially, this is coinciding with a clean tech sector transformation. Solar modules, batteries and electric vehicles (EVs) have become the cheapest options available for EM economic and sustainable development, as China’s ambitious manufacturing and deployment rollout has pushed prices down at extraordinary speed.
These improved economics have expanded the commercial opportunity set in EM and many of the associated investment opportunities reside in the private credit world. Deals made by Ninety One span the energy value chain – wind power generation in the Philippines, energy transmission lines in Brazil, a renewable data centre provider in Latin America, and Egypt’s first sustainable aviation fuel production facility.
Private deals in emerging markets also offer investors a favourable risk/return profile, which contrasts with a loosening of underwriting standards in parts of the US market. Across EM, there are plenty of investment opportunities that tick multiple boxes for investors: exposure to structural growth themes, attractive yields and strong deal protections – on loans to fundamentally strong borrowers.
AI – a disruptor and enabler
The examples above help explain how the EM private credit opportunity set is inherently heavy-asset, low-obsolescence (HALO).
These capital-intensive, physically irreplaceable assets contrast with the asset-light, software services business models that are increasingly prevalent in the US private credit market and appear most exposed to risks from AI disruption.
In EM equities, too, there are compelling comparisons to be made with the US around AI. The AI boom increasingly depends on hardware. A small group of EM firms sit at the physical limits of that infrastructure; the “Secret Seven” may represent one of the most overlooked opportunities in global equities today.
Against a backdrop of a global shortage of chips, AI-driven memory demand is creating an enduring tailwind for South Korea’s Samsung Electronics. SK hynix is another Korean firm benefiting from the memory upcycle underpinning AI infrastructure spend. Elsewhere, a number of companies are well-placed in the context of Taiwan’s AI-export complex and data centre supply chain demand. Some of these businesses trade at multiples that are just a fraction of the lofty valuations seen in the US today. Meanwhile, CATL is an example of a listed Chinese company with a true global edge: its EV Qilin battery supports a 1,000 km driving range on a single charge. The pace of AI development in the physical economy in China is also accelerating rapidly, including advances in autonomous humanoid robotics, as evidenced by a robot breaking the human half-marathon record.2
There are increasing parallels with the dotcom bubble, when EM equity valuations remained relatively low while parts of the US stock market overheated. The years that followed saw strong EM outperformance after the bubble burst. Today, we see similar dynamics emerging, making this the most compelling entry point for EM equities in 25 years, in our view.
Reasons to recalibrate investment views
From a more structural perspective, even as resilience strengthens the risk profile of EM assets, an enduring premium remains.
While the EM corporate credit universe is highly diverse and it’s vital to take a selective investment approach, the overall compensation for risk is generous. Across the EM universe, country-specific concerns often overshadow a company’s underlying fundamental strength, pushing yields above those offered by DM bonds of a similar credit quality.
This phenomenon extends to the private market space, where the reason for the favourable risk/return profile is an enduring barrier to entry. The inherent complexity of these markets and the years required to build local expertise and origination networks mean competition remains limited, and the premium shows little sign of eroding.
Taking a wider lens, with Hungarian 10-year government bond yields within around 75bps of their UK equivalents at the time of writing, there is a strengthening case for taking a more holistic view of global investment allocations.
With supply shocks becoming the new norm, traditional asset class behaviour shifting and old EM/DM distinctions breaking down, investors must rethink how they build resilience and diversification in their portfolios while positioning themselves for a transforming world.
1 Ninety One estimates exclude India (incomplete data set), Turkey (extreme values).
2 This is not a buy, sell or hold recommendation for any particular security.
General risks. The value of investments, and any income generated from them, can fall as well as rise. Where charges are taken from capital, this may constrain future growth. Ongoing costs and charges will impact returns. Past performance does not predict future returns, losses may be made. If any currency differs from the investor's home currency, returns may increase or decrease as a result of currency fluctuations. Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. 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.
