Uncovering the rich tapestry of emerging markets

Differences persist in emerging markets bonds

The scale of opportunities arguably means the EM debt market should also not be ignored by fixed income investors looking to diversify portfolios. Now a $24 trillion market, it has grown from representing just 2% of the global bond market in 2000 to an impressive 25% in 2022³. But here, also, important differences persist, as Michael Talbot, Fixed Income Investment Specialist, explains. 

“Each country is highly unique, with their respective economies driven by very idiosyncratic factors. Even within regions such as LatAm, Asia and Sub-Saharan Africa, there is often little commonality,” he says. “There may be broader trends like higher inflation in LatAm compared to Asia but within LatAm each country will have a slightly different experience of inflation driven by unique factors.”

For Talbot, these differences mean a selective bottom-up approach is required when investing in EM bonds.

When looking at GEMs, fixed income investors largely focus on economic development as the key differentiator. In addition, in EM debt markets there is also a choice to be made regarding currency exposure with some debt issued in hard currencies, such as dollars and euros, and some in local currency. Although today, the local currency debt market is many times larger than the hard currency market. 

These choices are important as performance can vary dramatically across region, bond rating and type. Talbot points out that the GEMs business cycle does not always follow that of developed markets (DMs) and currencies and regions might perform independently from one another, which support the view that EM bonds can be a diversifier from DM assets. They also demonstrate the importance of taking an active approach to contend with potential risks.

Actively benefitting from emerging market equities

Overall, the dispersion of market returns, certainly across the breadth of emerging market equities, has persisted as deglobalisation has accelerated. The (correct) response by many investors has been to become more discriminating in their allocations to emerging markets. There could be different ways to potentially achieve this:

A decision to exclude China, for example, may provide additional diversification benefits with the residual country exposures allowing a more diverse selection of industries, market structures, political and demographic profiles. Although developed markets offer investors a larger number of individual stocks overall to choose from, within emerging markets sectors such as semiconductors, electronic components, renewable energy and transport infrastructure actually offer more names than in developed markets.

These insights suggest simply investing in an overall GEM equity tracker fund may disappoint. The differences between individual countries are simply too great, with the additional concern that the index is dominated by a handful of countries. 

With important country-specific differences, diversity in sector exposure and divergence in performance, GEMs investors need the option to discriminate and construct their GEM allocations accordingly. In our view, adopting a highly active, bottom-up approach to emerging markets is key to securing long-term success. Volatility within emerging markets will usually present opportunities – having the flexibility and skill to capitalise on this likely determines performance. 

Spotlight on emerging Asia

A need to be selective within countries and sectors raises the question: Where should GEMs investors currently focus? One region at the centre of attention is Asia. Of the 6 billion people in GEMs, roughly 4 billion live in Asia. With its dynamic and evolving economic landscape, there are plenty of reasons why Asia is so prominent.

For a start, it can be seen as the engine of the global economy. China is the region’s powerhouse. Over the past 40 years, the country has been transformed through investment and export-focused manufacturing into the world’s second largest economy, behind the US. It has reshaped global trade, investment and supply chains and created a vast consumer market.

In addition to China, Asia has some of the fastest-growing economies in the world, led by India with an expected growth rate of 7% in 2024, according to the IMF. Collectively, the IMF forecasts that Asia is set to contribute about 60% of global growth in 2024⁴.

From an investment perspective, Asia stands out in GEMs as it represents around 80% of the MSCI EM Index. Asia’s dominance can be attributed to the four big markets: China, India, South Korea and Taiwan, which together make up 75% of the index.

According to Bourke, Taiwan and South Korea are similar. They are both relatively mature economies and are actually as rich as, if not richer than, many European countries, he says. In some ways they are not typical EMs but developed market investors struggle to categorise them so they remain dominant constituents of the EM world. They’ve thrived in recent years because they are technology heavy economies and integral parts of the global technology supply chain. “As major suppliers to both the West and China, in recent years they have benefited from growth in both those regions,” he comments.

While China and India are often compared to each other, they are very different. The fact that they both have populations in excess of 1.4 billion people might be one of the only things that they have in common. China is by far the larger economy, with a gross domestic product (GDP) of $18.53 trillion, more than four times India’s $3.94 trillion. Similarly, India has a long way to go in terms of its GDP per capita, which is currently $2,730, compared to $13,140 in China.

However, the different growth trajectories of the two countries have resulted in different perceptions. With significant scope for economic development, India is the current ‘growth darling’ of EMs, observes Bourke. Indian Prime Minister Narendra Modi certainly has ambitious growth plans for the country, seeking to boost per capita income and make it the third-largest economy in the world⁵. He has even spoken about making India a developed market country by 2047⁶.

As Vikas Pershad observes in his column elsewhere in this magazine issue, “much of India’s untapped potential lies in its demographic dividend”. With a large and young population – more than 40% of the population is under 25 years old⁷ – many of whom are English speaking, India has a huge and potentially highly productive workforce. Its domestic market also offers a potentially vast and diverse consumer base.

The current optimism around India’s future is in stark contrast to the prevailing pessimism about China. After years of rapid growth, investors are worried about the economy’s loss of momentum, represented by the struggling property sector and weak consumer demand. Geopolitical tensions with the US over trade and technology have also clouded views on China.

In many cases, these risks may already be reflected in share prices and contrarian investors might wish to explore China’s stock market for underappreciated stocks, as David Perrett argues in this magazine issue.

Just as GEMs are more than a homogeneous grouping, there is more to Asia than the big four. “The fact that those four markets are large and dominant doesn’t necessarily mean that’s all that’s going on in Asia,” says Bourke. “That’s frequently forgotten about.”

Some of the smaller markets have interesting drivers. Indonesia, for example, has a positive domestic story – as opposed to one closely linked to global growth cycles. “We often compare Indonesia to India. It’s fascinating as it has many of the characteristics that investors love about India. It has a relatively large and young population (c.283 million) that is expected to grow in the next few decades⁸,” Bourke highlights. 

India and Indonesia’s population pyramid 

Rising wealth in the coming years could lead to a growing consumer class and opportunities for financial services firms. Indonesia also has some exposure to commodities, including oil and gas, and nickel, which is a widely used component in electric vehicles.

As a relatively stable democracy – the country has recently held presidential elections – Bourke thinks Indonesia is an interesting source of investment ideas, particularly as the valuations are nowhere near as elevated as those in India.

Another market that Bourke considers attractive is Vietnam. Like India and Indonesia, it has all the classic hallmarks that draw investors to Asia, including a fast growing and young population. The economy has also been growing rapidly and is expected to expand close to 6% in 2024, driven by demand for its exports and foreign investment⁹. Vietnam has benefitted from rising geopolitical tensions and firms’ efforts to reduce their exposure to China, the so-called ‘China Plus One’ strategy. Bourke notes: “Vietnam has captured a share of the global supply chain as multinationals such as Samsung Electronics have based some of their production in the country to find a home away from China.” 

Considering these markets alongside Malaysia, Thailand, the Philippines, Pakistan and even Bangladesh, the range of investment opportunities that exist within Asia is extensive and, importantly, all quite divergent. From the economic powerhouse of China to the advanced technology hubs in Taiwan and South Korea to the fast growing, up and coming markets like Vietnam, Asia is a dynamic region that potentially offers some very exciting and varied opportunities for long-term investors.

Although the investible universe has some attractive structural trends, Bourke cautions that demographics or economic growth rates are not necessarily the core factors for GEMs investors to consider. He believes that understanding the big picture is valuable but what really matters for stock market investors is company earnings and valuations. These factors ultimately determine shareholder returns over the long-term. “Picking stocks is all about navigating where we think earnings are going. Our job as investors is to find companies where the future stream of earnings is not being accurately priced by the market,” he explains. 

There is a danger that GEMs investors fall in love with an investment narrative, be it robust growth prospects or demographics, and invest in stocks at any price. But for Bourke, who adopts a value-oriented investment approach, it is important to remain highly selective, careful and look for value right across the investment universe, even in areas that might be unloved. “GEMs’ diversity is your friend as an investor as it offers you the ability to go anywhere to find value and dilute potential risks,” he comments.

The cutting edge of innovation

Asia arguably has some of the most innovative and technologically advanced companies in the world. In some respects, it could even be said that the region offers a glimpse of what the future holds, from digital services to autonomous flying taxis set to take off in China next year¹⁰. 

Investors may not grasp Asia’s position at the forefront of technology. The artificial intelligence (AI) frenzy over the past two years has focused mainly on large US companies such as Nvidia, but it is worth remembering that Asian firms like Taiwan’s TSMC and South Korea’s SK Hynix are critical players in the global AI supply chain.

With considerable technological skill and know-how, they make the advanced chips used in AI applications and data centres as well as smartphones. TSMC held 62%¹¹ of the global market share for chip making in the first quarter of 2024; with such cutting-edge capabilities, Asia’s reputation as a manufacturer of low-cost, low-quality goods clearly needs to be rethought.

China’s Huawei is also competing in the AI race. The company recently announced it has developed advanced chips that it says are comparable to those designed by Nvidia¹². In the world of technology, it could be argued that Asian firms, most notably in northern Asia, should be considered as global leaders, on a par with, if not ahead of, Western firms. 

The same could apply to the electric vehicle (EV) market, where Chinese firms such as BYD and Nio are setting the pace and capturing market share at the expense of established Western car brands. With innovative technology and reasonably priced, high-quality vehicles, BYD is now competing with US firm Tesla. 

Besides EVs, Chinese firms hold dominant positions in other industries of the future such as solar and wind power, and batteries. While Chinese manufacturers may face trade restrictions in accessing Western markets, they are arguably well placed to expand into the large markets within Asia. 
 

The future of banking

In the banking sector too, Asia is in the vanguard. Asian companies are at the forefront of redefining the concept of a bank through innovation and seizing opportunities, observes Pershad. He points to digital banks from China’s tech giants Alibaba, the owner of Alipay, the world’s largest mobile and online payments platform, and Tencent.

In India, the Unified Payments Interface (UPI), developed by the National Payments Corporation of India (NPCI), has revolutionised real-time payments, enabling instant money transfers between any two bank accounts through mobile platforms. UPI has significantly increased the penetration of digital payments in India, providing a safe and accessible digital payment structure for consumers.

In a region where many adults lack access to banking services, digital banks are poised to bridge this gap. “Neobanks such as Vietnam’s Timo and the Philippines’ Tonik are leading the charge, providing digital-only services tailored to the needs of the unbanked and underbanked populations,” he says.

With just a smartphone, individuals in remote areas can open accounts, conduct money transfers, and apply for credit.

Pershad believes Asia’s banking sector is on an exciting trajectory, driven by transformative developments as it prioritises innovation, inclusion and profitability. “By embracing this wave of change, investors can potentially not only contribute to the growth of the region, but also capitalise on the vast potential offered by Asia’s evolving financial landscape,” he says. 

Flexibility and selectivity

This dynamic economic landscape justifies Asia’s prominence in the GEMs investment universe. However, active GEMs investors have the freedom and flexibility to look even further afield in search of attractive opportunities. The performance of GEMs can be as divergent as their economies are idiosyncratic. Economic conditions and cycles vary across GEMs and a truly global approach to investing in this asset class can help equity and bond investors navigate risks and volatility. 

There are potentially plenty of reasons why investors might be excited about opportunities in GEMs, but it’s important to remember that when it comes to equity investing, fundamentals, company earnings, profits and valuation are what really matters. The challenge therefore is to find companies that can harness structural growth trends or innovation profitably, at attractive valuations, rather than simply buying the EM growth story. For Bourke and Talbot, the search for value requires a careful, bottom-up approach to investing.

Despite favourable prospects, GEMs have struggled to attract the attention of global investors in recent years as an asset class. Instead, capital has flowed principally to the US, and in particular the mega-cap tech firms. This has created a wide discrepancy between the economic significance of GEMs (c.50% of global GDP13) and its c.10% weight in the global equity index. Amid concerns about the valuations of US stocks, could we see investors broaden their horizons and look for opportunities in global emerging markets in future?

These scenarios all reinforce the need to maintain investment flexibility across EM countries and sectors, to be highly selective in stock selection and maintain a disciplined focus on fundamentals as opposed to simply ‘buying the EMs growth story’.