Not all emerging markets are created equal, and the fundamental differences between many of the different regions in the emerging market universe are stark.
Emerging market equity investing just 10 to 15 years ago largely consisted of trying to exploit GDP growth across the universe and hoping this translated into company earnings. Investors could buy areas such as Chinese cement, Russian steel and Brazilian iron ore. But this time has well and truly passed.
There are new innovative leaders evolving in today’s diverging emerging markets, which are largely being driven by changes in technology, demographics, globalisation and sustainability. It is therefore unfair to paint all emerging markets with the same brush.
Unlike the boom times, when most emerging markets moved higher in unison, a ‘three-level’ emerging market dynamic has evolved – with each displaying differing fundamentals and drivers.
Firstly, there are the highly advanced economies – the likes of Korea and Taiwan. These advanced and innovative economies by many classifications are on par with developed market countries. For example in literacy and education Korea and Taiwan outperform the majority of developed markets. These economies are still classed as ‘emerging’ due to issues such as foreign access and corporate governance, but are making strides in addressing some of these challenges.
Secondly, there are the ‘evolvers’, primarily those economies not reliant on natural resources. While a number are at different stages of development, all these countries face challenges of implementing effective reforms. The eyes of the world have firmly been on China recently, as the communist economy seeks to transition away from its many years of reliance on investment and manufacturing, to a more service-based economy. While the great China GDP story is unlikely to return it has led to the rise of new Chinese innovators – in areas such as technology and healthcare.
But it is not only the Chinese economy going through this transformational phase. The likes of Mexico, Thailand and the Philippines are also looking to implement long-term economic structural reforms. Another example is India, following the election of reformist Prime Minister Narendra Modi in 2014. While Modi faces numerous obstacles in his bid to transition the Indian economy away from its agricultural roots, reform remains on path.
Finally, the remaining are the ‘questionmark’ economies – namely those in Latin America, as well as South Africa and Russia. These resource-reliant economies were too complacent during the commodity bull market and did not take any significant action to adjust the imbalances inherent in their respective economies. The boom – largely driven by decades of phenomenal Chinese resource consumption – fuelled excesses in these countries and created environments primed for extreme corruption, which many are still struggling to combat. While investors cannot totally ignore these markets, extreme caution is required.
Despite the long-term positive and negative cases for many emerging markets, it has been tough to make any argument for investing in the asset class in recent years. Many factors have caused investor nervousness, the largest of which is transitioning the Chinese economy.
Another negative contributor is the Federal Reserve’s tightening cycle. After the effects of the taper tantrum on emerging markets in the summer of 2013, it heightened the substantial scepticism towards the asset class. While rate hikes will clearly result in volatility, most market participants certainly do not expect the US to undertake a prolonged or rapid tightening cycle. In fact, with technology, globalisation and demographics changing the world as we have known it, we could be facing structurally lower interest rates than we have historically been accustomed to.
Despite recent poor performance and all the downbeat headlines, we see a strong valuation case for emerging markets and still believe the negative sentiment being priced into the market is beyond the fundamentals.
Jorry Rask Nøddekær, manager of the Nordea 1 Emerging Stars Equity Fund.