Emerging market performance might have been lacklustre over the past decade, but structural changes in these markets mean they are likely to turn the tables on developed markets in the years ahead, Martin Currie says.
In the 1967 book, Cien años de soledad (One Hundred Years of Solitude), by Colombian author Gabriel García Márquez, the character of José Arcadio founded the city of Macondo.
Initially, Macondo was a utopia. Situated near a river, it was a city of mirrors that reflected the world in and around it. But shortly after the creation of Macondo, the family central to the tale started to face a series of misfortunes and the city of mirrors became one of mirages.
Paul Desoisa, Portfolio Manager for Global Emerging Markets at Martin Currie, sees an analogy with how investors have been looking at emerging markets.
The initial optimism about the favourable demographics and rapid economic growth made way for dread as the rise in gross domestic product (GDP) failed to translate into stock market expansion, while the United States equity market experienced a decade of unprecedented growth.
But the performance of the US stock market over the past decade has been unusual, Desoisa says. He calls it the “decade of dominance for the US” and believes the future is likely to look very different.
“Without a doubt, the US equity market has been the place to be over the past decade. Supportive monetary policy helped drive a re-rating of the market, but also at a company level we saw higher returns from expanding margins and buybacks,” he says in an interview with [i3] Insights.
“But it seems unlikely that the US will have another decade of such dominance and the question there is: Will we see accommodative monetary policy to the extent that we saw previously and can margins continue to go higher? And to us, that seems unlikely.”
Without a doubt, the US equity market has been the place to be over the past decade. Supportive monetary policy helped drive a re-rating of the market, but also at a company level we saw higher returns from expanding margins and buybacks. But it seems unlikely that the US will have another decade of such dominance
At the same time, emerging markets have faced some significant headwinds over the past 10 years.
“We’ve had to deal with what I would call some significant bends in the road and I think one of the most significant examples of that has been investors’ hesitation around China,” Desoisa says.
“If you were to split the last decade into two discrete periods, say between June 2013 and Q1 2021 and then from Q1 2021 to now, and if you looked at that first period, then I think it would come as a surprise to many people that the MSCI China Index actually outperformed the S&P 500 in total shareholder return in Aussie dollars by double digits.
“So it actually had a long period of outperformance against the S&P 500. Since then, it has underperformed dramatically. But what that has created is a valuation gap between China and the US.
“The hesitation that we’re seeing from investors regarding the US-China relations … we think the practical reality will ultimately prevail there. Both countries need to cooperate because of the economic realities. We think that will drive attention back to the Chinese market and hopefully drive a re-rating of the market.”
Many emerging markets also find themselves in a very different place than 10 years ago. Whereas in the past most markets relied heavily on the production of resources and cheap manufacturing, increasingly markets have shifted towards services and the production of value-add goods.
“I would describe the backdrop of emerging markets being supported by a higher-quality index than in the past,” Desoisa says.
“Over the last decade, we really have seen some material shifts at sector and country level. For example, the energy and materials sector, the combination of those two sectors used to represent about 30 per cent of the index. Today it’s about 14 per cent.
“The issue with those sectors is that they are cyclical and they lack structural growth opportunities.
“The good news is that we’ve seen a significant increase in exposure towards the technology and consumer sectors in the EM index. And those companies tend to have stronger business models, less cyclicality and stronger structural growth drivers.
“But we don’t think the relative valuation of emerging markets reflects that change.”
India Leads the Way
The International Monetary Fund (IMF) is optimistic on the outlook for emerging markets over the next two years.
The IMF expects emerging markets will outgrow advanced economies, forecasting 4.0 per cent GDP growth for emerging markets, against just 1.2 per cent for developed markets.
China and India are expected to be key drivers of this, contributing close to 50 per cent of that growth estimate.
India, in particular, is likely to show fast growth. The country is expected to see an increase in real GDP of 6.1 per cent this year and 6.8 per cent in 2024, one of the fastest growth rates in the IMF’s World Economic Outlook, with the exception of a handful of frontier markets.
This growth is partly driven by favourable demographics; the average age of India’s population is only 28. But when it comes to India, it is not just about demographics, Desoisa says.
“There has been a lot of structural reform in India over the past few years and there is an Indian saying which says: ‘Where the needle goes, the thread follows.’ So there’s been a lot of needlework in the form of reform over the past few years and now the thread, that is, economic growth, is following,” he says.
He is particularly excited about the developments in the Indian banking sector. This sector has seen the fastest loan growth since 2011 and combined with good asset quality it is driving significant earnings growth for these banks.
There has been a lot of structural reform in India over the past few years and there is an Indian saying which says: ‘Where the needle goes, the thread follows.’ So there's been a lot of needlework in the form of reform over the past few years and now the thread, that is, economic growth, is following
They are also expanding their client base through the application of technology, making it easier for people to get access to banking services.
“They are not hampered by the legacy systems that we see in developed markets and have really accelerated their investments [in technology] over the last few years,” Desoisa says.
“For example, there is a company called Kotak Mahindra Bank and that company has built a digital bank, which has attracted 13 million customers in five years. So about a third of the bank’s total customers are now digital customers.”
Once this phase of high expenditure on technology slows down, the fruits from their labours should become visible in the banks’ bottom lines.
“They’re in a real sweet spot at the moment,” Desoisa says.
China’s Shift to Quality
China is by far the largest country among the emerging markets and represents about 30 per cent of the MSCI Emerging Markets Index.
Desoisa sees great potential in China’s shift away from the manufacturing of low-cost items to high-quality manufacturing. The country has been developing some leading products in the sectors of healthcare, biologic drugs, green energy, solar glass, batteries and automation systems.
China is now at a stage where local players are starting to be preferred over developed market brands.
“Local players have closed technology gaps in many areas and can provide their products with material price savings for the customer, but also offer a superior after-sales service,” he says.
“That is driving a significant gain in market share for local Chinese players.”
Local [Chinese] players have closed technology gaps in many areas and can provide their products with material price savings for the customer, but also offer a superior after-sales service
Desoisa owns Shenzhen Inovance in his portfolio, a Chinese A-share company that manufactures and distributes industrial automatic control products and new energy-related products.
“It has been probably the biggest beneficiary of this shift that’s been taking place towards high-quality manufacturing,” he says.
Another example is Contemporary Amperex Technology Limited (CATL), a Chinese manufacturer of batteries. This company has benefited from China’s shift towards electric vehicles (EV).
“China is currently the largest EV market in the world; about one in three new cars sold are defined as new energy vehicles,” Desoisa says.
“We’ve been playing the battery industry through both Korean and Chinese companies, but CATL has been very, very well placed.”
The Role of Technology
Technology is a recurring theme when it comes to investing in emerging markets. But Desoisa says investors have not quite realised the magnitude of the role technology plays in the future growth of the global economy, not just emerging markets.
He says politicians have shown a keener sense of the importance of emerging market companies in this dynamic.
For example, the decision of Taiwanese semiconductor manufacturer TSMC to establish a semiconductor fabrication plant in the US state of Arizona is largely made possible by generous subsidies from the US government.
“It is a way to ensure chip production is secure in the case of an invasion of Taiwan,” Desoisa says.
“I think the political world realises how much the world is reliant on emerging market companies, for example those based in Taiwan. But I don’t think the financial market truly understands the value they bring and the lack of alternative options out there,” he says.
“Nvidia, for example, which is making a lot of headlines at the moment because of the artificial intelligence growth opportunity, the reality is that it is totally reliant on TSMC for the manufacturing of its products.
“Without TSMC, Nvidia would be in a very tricky position. So EM companies are not just powering emerging market growth, they’re also powering world growth as well.”
This article is sponsored by Martin Currie. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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