Is it time to invest in emerging markets?

Conventional wisdom sees emerging market shares (EM) as a good idea when the dollar is weak and the world economy and stock markets are in an upswing. EM shares are seen as a higher-risk asset class than advanced country shares. They are often bought as we come out of recession and slowdown and avoided when interest rates are rising, economies are stalling, and world trade is suffering. They are perceived as having considerably higher political risks than advanced countries, with more settled systems based on democratic governments and the rule of law.

It is true that many EM economies with dollar borrowings and exposure to world trade do better when the dollar falls and borrowings get cheaper as interest rates are cut. It is also true that some emerging-market economies have more extreme risks politically. We saw this again with Russia when it invaded Ukraine and much Western capital had to exit in a hurry – if it could.

There are examples of stock markets with high levels of volatility in the emerging world. There are cases of EM countries allowing very high inflation and imposing substantial controls on companies operating there. There have been good recovery runs in various EM markets over the years. It is easy to buy into the MSCI EM index, or to find an active manager who specialises in these markets.

There are some EMs that have established democratic governments and who have more of the characteristics of advanced countries. Some of the countries that will benefit from a world upswing are not in the EM index but are classified as “frontier markets”.

So, 30% of the MSCI EM index is weighted to China, the world’s second largest economy with a single-party authoritarian government, and 27% to Taiwan and South Korea. These latter two economies have achieved advanced country living standards and levels of income but are still classified as EM and not advanced by MSCI. This is mainly because of the lesser liquidity and other issues with their stock and bond markets.

What is the Emerging market index composed of?

South Korea qualifies as “developed” in the International Monetary Fund (IMF) listings. Just as the advanced world index performance has come to be led by successful technology giants, so the top four stocks in the EM index are Taiwan Semiconductor Co (TSMC) at 6.6%, TenCent (4%), Samsung (3.9%) and Alibaba (2.6%), which together account for 17% of the total weighting. The superior growth of the digital world is there reflected in the Index.

Not all emerging markets are the same

The heavy orientation to just five countries in the index and the 30% share of China means it is worthwhile undertaking specific analysis of these main countries. It may often be better to select from amongst those five the countries that best meet requirements and prevailing market conditions. It reminds us that many of the arguments about dollar debts and political risks apply more to the range of frontier markets than to the main emerging markets identified in the MSCI Index.

The contrast between the performances of China and India over the last two decades is especially noteworthy. The Chinese Index still languishes well below its 2007 high, whilst the Indian Sensex Index has regularly made new highs throughout most of the last twenty years. Markets have been more responsive to Indian growth, seeing it increase the profits of quoted companies and the range of listed businesses on offer. In China, markets have responded less well to state interference, to the more recent property crash, and to the large role of nationalised business and regulatory directions in the excellent growth rate achieved by the economy overall.

Investors see a high degree of political risk in China. They anticipate continuing stability of the governing system under one-party rule, but also expect state direction – which may not be favourable to foreign investors. Overseas buyers of Chinese equities do so very much on the terms of the Chinese state. There may be occasions when they allow foreigners to make money, but the foreign investor is not high up their list of priorities.

Beijing’s decision to allow major property companies to go bust and walk away from dollar debts was a reminder of what can happen when the state changes its view on important companies or sectors. The administration is currently able to provide some stimulus to get more growth, has low inflation and may even want equities to move higher, but buyers will be dependent on the authorities’ goodwill.

Brazil has tempestuous democratic politics and has recently elected Lula da Silva to another term as president after the Bolsonaro period. He has kept the stock market happy – so far – with the promotion of economic growth and more spending balanced by tax increases. The president is not being boosted by a commodities boom, which gave substantial help to him to achieve good growth in his first period in office, but he is benefitting from the relatively low inflation rate. Price rises are now down to 4.7% and the central bank has significant room to cut interest rates further as they are still in double figures. The president is willing them down.

General Investor sentiment

There is plenty of disagreement amongst professional investors about whether Ems are now good value and whether they are investable. Some take the view that the extra political and market risks are not properly rewarded and can, in the case of an individual market such as with Russia, result in substantial losses if things go wrong.

Some take the view that emerging economies will grow faster than advanced nations, as they can narrow the gap of incomes by adopting proven technology from the successful countries. This, they think, should result in better long-term returns. Others see that emerging market economies are variously defined by index providers and world rating agencies and are probably better considered on their individual merits, especially in the case of the larger ones.

In our recent reviews, we have said we still like India and Taiwan - but these are now at the expensive end of their valuation ranges. They remind us that looking for a cheap entry point for EM as a whole after a bear market in 2022 and mixed views in 2023 does not necessarily provide opportunities to buy shares in the better companies cheaply. Taiwan remains a play on the semiconductor cycle, which is past the peak of 2022 whilst benefitting from the AI investment drive. India gets foreign buyers of its shares on the basis that it is more acceptable to invest there than in China – and it has much further to go to catch up with advanced country living standards.