Andrew Ness surveys the emerging market landscape as he sees it today; and challenges some of the more widely-held preconceptions
There has been huge change in the emerging markets sector in the last quarter century and the quality of the asset class is much improved; but outdated perceptions persist. The risk is that investors miss the transformation of these economies and systematically under-allocate to one of the more exciting growth opportunities in the world today.
The new emerging markets landscape is one of new realities; and there are three components to this.
The first is that the emerging market policy makers have deliberately changed the policy environment and structure of their economies for the better, to make them much more resilient during periods of external stress and shock.
Market historians will recall that December 1994 was the year of the “tequila crisis” in Mexico – a classic emerging market currency run. The government was pump-priming the economy ahead of an election; and operating in a fixed exchange rate regime, borrowing offshore in cheap dollars.
Eventually the peg had to go and the result was significant devaluation, hyperinflation and a really severe social and economic recession. The real economy was contaminated badly; and Mexico has yet to fully recover.
Following that, in 1995, there came the rand crisis in South Africa; in 1997/1998 the well-known ASEAN crisis in the Far East; and things culminated with the Russian implosion in 1998/1999.
For many emerging market investors, these crises still resonate; and this is one of the misconceptions I referred to, because things are now fundamentally different.
So how are they different?
Some of the differences are down to FX reserves. There is now a considerable balance of FX reserves across the asset class that, whilst it will not be fully protective of economies and currencies in periods of stress, does give some form of resilience to these periods which in the past would have led to massive contamination of real economies.
And sources of borrowing have diversified. A lot of the ASEAN and the Mexican crisis could be attributed to the fact that they were borrowing with a big currency mismatch: borrowing offshore in cheaper dollars without that natural hedge.
One of the beauties of the development of the capital markets over the last two decades is the extended domestic yield curves and maturities brought about by being able to issue your own paper.
There are other differences.
Take the balance of payments situation. Large current account deficits and balance of payments deficits were being run back in the early ’90s; now we are moving much more towards balance, if not positive balance, with current surpluses being the norm in many emerging economies.
And emerging market banks, are typically much better capitalised, better regulated, and better supervised than at any point in my investing career.
None of this is to say that there is a full immunisation or protection of our asset class from excessive shocks, but it gives an ability to be flexible.
Currency regimes are now partially floating or fully floating; no longer fixed exchange rate regimes. That structural change in the policy framework is still underappreciated by the marketplace.
That is the first new reality.
The second new reality is that emerging market economies have diversified. Consumption and technology are the new drivers of growth. If we go back a couple of decades, emerging markets were largely about low-cost manufacturing and export; not a huge domestic story, not a huge value-added story domestically either.
In 1988, Malaysia, Chile and Brazil accounted for 63% of the MSCI index; they now account for less than 10%.
The sector has gone from being dominated by commodity, old economy, dependent economies with the cyclicality in cash flows and the cyclicality in economic cycles that brings, to being much more dependent on domestic revenue sources.
If I go back to my starting days, my first couple of investments were in central European companies: a Hungarian cardboard box manufacturer; a Hungarian sausage company; and a Polish tyre company. Not a huge amount of sophistication; not a huge amount of added value. Fast forward to where we are today and it is a very different picture.
New paths to development
The third new reality in this changing landscape is that emerging market companies and countries are not following the traditional development path that we saw in the West. They are leapfrogging that path, often through innovation and technology.
It is a common fallacy that the past predicts the future; and when investors look at the emerging markets asset class, they tend to assume its companies and countries would simply follow the same development path as the West.
That is wrong.
There are countless emerging market companies and countries at the forefront of implementing digitisation of industry and disrupting the traditional business model; whether it is in ecommerce, mobile banking, payments, electric vehicles or 5G technology.
If that is the landscape, how does that then translate into the holdings of Franklin Templeton’s Emerging Markets Investment Trust (TEMIT) portfolio?
There are a number of themes we have currently got exposure to. Technology, for example. There is a reshaping taking place in the global economy and there are many levels on which we can participate in that reshaping. We can buy ecommerce assets – we are seeing leadership in the likes of Korea and China in that space – but ecommerce is a theme and there is an investible opportunity in many other economies. So we have got exposure in Korea, China and the likes of Russia and Brazil. And this is still a low penetration story, so there is plenty of scope for long-term growth.
On the disruption side, there are two angles. We can invest in those businesses that are disrupting traditional business models in sectors such as food delivery, online booking, finance, distribution and financial services; but we can also invest in the enablers of disruption, those companies building the hardware and the software and the digitisation networks that are making that disruption possible.
The consumer theme is increasingly important, with premiumisation becoming an interesting twist in the story.
There is a growing middle class in many emerging countries; and once you get a little bit more wealth, once you get a little bit more stability in your personal finances, you like to upgrade your consumption patterns – buy a better watch, go to a bigger cinema screen, drive a better car. This is the premiumisation trend going on now in many parts of the emerging world –and it is potentially huge.
Corporate governance has always been a headwind for the asset class and quite rightly so. Some of the abuses have been horrific. But it is now becoming more of a tailwind. We are seeing lots of evidence to support that; from the issuance of governance codes by various emerging market governments to the issuance of stewardship codes to encourage local investors to up their game as more active stewards.
The use of the World Bank ease of doing business indicators as a framework is testament to the fact that these economies are becoming more investible.
We can see better capital discipline, a greater alignment between management teams and investors and that is manifesting itself in increased distribution and buyback activity.
There is definitely a wind of change in the corporate governance world that I do not think is fully recognised and is the potential source of a longer-term rerating of the asset class.
In the TEMIT portfolio there are typically 70 to 100 names. We are currently sitting at just over 80 high conviction or top 10 stocks. Our top 10 stocks make up over 40% of the portfolio. There is a longer tail of names that we are monitoring and looking for these to be the next compounders within our portfolios.
Country and sector are a consequence of our bottom-up stock decision process. Over that 30 years to the end of June last year, TEMIT had compounded 12.7% pa, MSCI index had given you 9.1% pa. So £1,000 invested in June 1989 would have got you to £36,000 last year. To put that in context, that same £1,000 in the index would have given you £18,000; and that same £1,000 in the FTSE would have given you £10,000 to round it up.
For those of you who say that emerging markets do not give you returns, they can and do; and I think there is plenty of evidence there is the potential for that to continue.
Andrew Ness is an emerging markets portfolio manager at Franklin Templeton, and the joint core manager on TEMIT – The Emerging Markets Investment Trust.