If you have the luxury of a long-term investment horizon, patience can pay off.
Making the case for investing in emerging markets has never been easy. There has always been a struggle between the lure of higher returns and the suspicion that, sooner or later, disaster or instability could wipe them out.
Indeed, a series of shocks – including the Latin American debt crisis of the 1980s, the Asian financial crisis of the 1990s and concerns about higher interest rates in the United States in 2013 – have repeatedly led investors to withdraw their capital, causing a boom-and-bust pattern.
Questions remain about how many emerging market countries can actually achieve developed status, or about the justification for investing in emerging market stocks from a returns perspective.
But none of this necessarily means that emerging markets are not worth investing in. On the contrary, there are many signs that the best may be yet to come.
So, looking ahead, what is the appeal of investing in emerging market stocks and how can stock pickers succeed in this specialized discipline?
Growth on the horizon
These days, when arguing for an allocation to emerging market equities, the emphasis is usually on relative valuation, which is quite reasonable: the asset class has not moved in a decade, while developed markets (led by the US) have been doing better and better.
These valuation-driven arguments are increasingly complemented by a new appreciation for the macroeconomic resilience of emerging markets.
It’s true that we’ve just gone through the most aggressive Federal Reserve tightening cycle in a generation, and most major emerging economies have emerged unscathed, but there’s not enough discussion about the case for growth in emerging markets.
We are constantly told that the golden age of globalization has come to an end and that emerging markets, as the biggest previous beneficiaries of this trend, will be the hardest hit by its reversal.
What we are seeing, however, is not deglobalisation but sinification, with the West trying to push China out of its system. There will be winners elsewhere in emerging markets as supply chains tighten, new export champions emerge in countries such as Vietnam and Indonesia, and capital flows into those markets.
A shifting centre of gravity
Stocks in Mexico, South Korea, Vietnam and India are finally attracting more attention after a decade of neglect.
That’s because when it comes to the key challenges we’re likely to face in the coming decades, many of the answers lie in the developing world.
If we think about the transition to renewable energy, we are going to need a huge amount of critical minerals: copper and nickel.
If we think about the revival of the manufacturing sector in developed markets, we are going to need a lot of steel and cement. And if we think about artificial intelligence (AI), we are going to need a lot of semiconductors.
When I think about all of these things, the idea that the world’s economic center of gravity will continue to shift toward emerging markets seems very plausible.
The macro issue
So what does it take to take advantage of this shift in headwinds? The extreme nature of cycles in emerging markets means there can be long periods when top-down factors are overwhelming.
Some investors will say that macroeconomics doesn’t matter, that what matters is finding great companies and focusing on fundamentals. But I would say, with all due respect, that it does matter in emerging markets.
If the right companies are chosen at the wrong time, currency fluctuations and tighter lending standards can cause the value of emerging market stocks and bonds to plummet. But the results can be stellar when both factors work in one’s favor. And there are signs that suggest such a period is on the horizon.
We are still below the 2007 peak in the MSCI Emerging Markets Index at a time when other global stock markets have performed well and more capital has flowed out of emerging markets than has flowed in for the better part of a decade.
The result is that asset prices appear undervalued compared to other markets and more and more world-class companies are emerging in emerging markets.
World-class companies
Take Taiwan Semiconductor Manufacturing Corporation, better known as TSMC, for example. It has a market share of around 60% in third-party chip manufacturing and counts Apple, Nvidia and Qualcomm among its major customers.
In the 1990s, it was roughly twice the size of its nearest competitor, United Microelectronic Corporation. Now, it is six times larger. It got to that point by doubling down on every downturn, while its competitors cut back on spending.
No one knows what the new digital era will look like or which AI applications will be most successful, but we have a pretty good idea that TSMC will make the semiconductors that power them. I think the market hasn’t yet realized the value that could create.
India also has many promising startups, while its biggest brands are benefiting from rising disposable incomes of the public. Much of this potential is already reflected in valuations. However, Jio Financial Services is an example of a company whose prospects are particularly bright.
There are hundreds of fintech companies in India. What makes this one special is that it is backed by Reliance Industries and has access to all its data. We are talking about 400 million telecom customers and 200 million retail customers – it is a powerful combination.
Patience can pay off
We can go quite far in imagining where the tilt toward emerging markets might take us.
If the early 2000s were about the integration of China and the West, the 2020s are set to see something much broader: 4 billion people in more than 100 emerging market countries doubling down on business investments with both sides of the geopolitical divide.
The evidence for this is that it is already becoming an economic reality: emerging market countries are trading with each other more than ever before, and increasingly in currencies other than the dollar, further freeing emerging markets from their historical dependence on US policy.
The benefits of this new wave of globalization are likely to be reinvested in emerging markets themselves. It could be a much more powerful and self-sustaining trend than any that has developed so far.
Anticipating these long-term dynamics is easier than trying to time the turning points of cycles: a crash is followed (at some point) by a withdrawal of supply and a stimulus, followed even later by a recovery. So if you have the luxury of a long-term investment horizon, patience can pay off.
Will Sutcliffe is the head of Baillie Gifford’s emerging markets equities team. The views expressed above should not be construed as investment advice.
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