Exploring emerging markets

Cheap, underperforming and unloved, EMs are often seen as a contrarian trade but Russell Investments thinks the often maligned sector should be a core part of equity and even fixed income portfolios.

Monday, July 31st 2023, 3:36PM

by Andrea Malcolm

Russell CEO Matthew Arnold says Kiwis don’t invest in emerging markets (EM) stocks at all, and most funds are underweight because “it’s quite hard to do.”

“Not many NZ fund managers trade in them so there are a limited number available to NZ investors in tax efficient wrappers.”

Russell’s Global Share Fund currently has a 12.33% weighting towards EM via specialists Red Wheel and Oaktree Capital Management.

Redwheel investment committee and co-portfolio manager Thomas Allraum says the firm thinks that after a decade or more in the doldrums, we are entering a period of emerging markets outperformance.

Although its approach is to not shadow indices, Red Wheel’s EM strategy benchmarks to the MSCI EM index which covers 24 emerging markets and includes Taiwan Semiconductors, Alibaba, Tencent, Samsung and Infosys among its top constituents.

Five year returns are 0.95% compared to the developed markets-only MSCI World index with a five year return of 9.07%.

Allraum says looking at EM performance versus the US over the past 30 years, there have been two super phases. The rise of the Tiger economies over the 1980s-1990s, followed by a series of EM crises over the rest of the century, and then the rise of China in the first ten years of the 21st century, followed by a ‘lost decade’ which should have ended earlier but was extended by the pandemic.

“But currently EMs are ahead. They didn’t over stimulate during the pandemic, raised rates earlier, inflation has started to go down much quicker, and they will lower rates earlier.

“We also see that, although GDP growth is slowing, the GDP growth differential between developed markets (DM) and EM is starting to accelerate. A pivot from zero-Covid policy in China has seen China’s growth returning, while US dollar stabilisation or devaluation, and global deflation are key tailwinds for EM this year.”

This has all made for attractive valuations and positive earnings momentum, says Allraum. “Profitability, free cash flow and dividend yields have all moved higher. Earnings growth is expected to recover in 2023.”

Red Wheel takes geopolitical advice from the international strategic consultants Rice, Hadley, Gates and Manuel including former US Secretary of State Condoleeza and former US Defence Secretary Bob Gates.

Allraum says there are several themes providing EM tailwinds for long term growth. One of these is a global capex recovery following years of structural disinvestment.

“The EM index is tilted towards capex plays. Capex is increasing because of significant investment in renewable energy, increased EV infrastructure spend, a global pickup in defence spending, and nearshoring all of which will drive demand for materials.

“Capex in defence is very materials intensive. I remember Bob Gates saying shortly after Russia invaded Ukraine that defence was going to be a theme for the next 30 years. A lot of that is materials intensive and EMs bias towards IT capex.

Net Zero targets and sustainable energy growth also play into this by driving demand for green metals such as lithium, nickel and copper.

“Green materials largely come out of emerging and frontier markets. There are very few developments of mining for copper and lithium in developed markets.

“Generative AI has emerged as a new structural growth driver for tech enablers. This is a little bit like a gold boom. Picks and shovels are where you want to be at the moment. So tech hardware really comes out of EM.”

A weak dollar also means EMs are strong, he says. “A lot of EM companies are linked to commodities which tend to do much better when the dollar is weak. When the dollar is strong it invites everyone to invest in the US because you will have a tailwind in terms of performance in the US. When the dollar is weak people look elsewhere.

“The dollar has been strong but has been weakening recently and we think this will accelerate. Our economists think we will have a global soft landing but some of the facts that will impact the dollar over the next few years are the Fed is pausing and we think they will pivot towards easing sometime next year. The Fed will go before Europe and the dollar will weaken against the Euro which has a significant impact on the dollar index, so we think emerging markets will do well because of the inverse relationship between the two.”

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