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Not all emerging markets are equal: Tread carefully when chasing returns

By Investec 15 May 2019

Emerging markets are often favoured due to their growth potential, which generally exceeds that of more developed economies. However, investing successfully in emerging markets is not without nuance.

Just last week, hundreds of billions of dollars were wiped off emerging market assets, as the re-escalation in the US-China trade war drove investors to withdraw their money back into developed market safe havens.

According to the recent Investec Global Investment View Q2 2019 report, it is critical that the US and China can reach an accommodation on trade, “because the imposition of the full slate of threatened US tariffs upon China would be a global stagflationary shock”.

Investors are hoping the negotiations will get back on track when Trump and Jinping meet at the G20 summit in June.

If a trade war is averted, emerging markets are expected to continue on their upwards growth trajectory on the back of slower US growth, says the report. “The US economy is expected to slow as the stimulus of tax cuts wanes, but Europe and the emerging economies are expected to improve, helped by easier monetary conditions, better terms of trade, lower oil prices and an improving political backdrop.”

“We expect emerging markets to outperform developed markets, since they should see a cyclical catch-up in earnings and dividends,” concluded the report that is compiled by Investec’s Global Investment Strategy Group (GISG).

Risk vs reward

Risk versus reward is a litmus test that should govern every decision an investor makes. In the hunt for market-beating returns, investors are often willing to assume greater risk for potentially bigger payoffs, either through their strategy or the geographies within which they invest.

We asked members of the GISG for their take on whether, in today’s world, developed markets are more or less risky than emerging markets, and what investors should consider when investing in the likes of India, Russia, Brazil and South Africa.

“Developed markets are, in general, less risky from a policy, political and a corporate governance perspective, but everything comes at a price,” explains Ryan Friedman, Multi-manager Investments Head, Investec Wealth & Investment SA.

Developed economies are, of course, conducive to stable long-term growth, which appeals to most investors. In contrast, emerging markets can be volatile. Prof Brian Kantor, Chief Strategist and Economist at Investec Wealth & Investment SA, explains that this lack of long-term certainty is the main risk that emerging market investors must consider.

“This risk must be traded-off against the potential returns offered by a specific emerging market for an investment to make sense. As developing economies are generally growing from a lower base, there can be significant upside potential. Emerging economies that apply lessons from the developed world or adopt new technologies could also leapfrog developed countries to deliver significant returns.”

READ MORE: Emerging markets back on the boil in 2019?

Consider individual differences

The key is understanding the country-specific dynamics at play as no emerging markets are the same. “For example, countries like China, Korea and Taiwan are considered emerging markets, yet all have the characteristics of a developed economy,” says Kantor.

In contrast, many high-growth African countries are also included in this collective term, yet their fundamental characteristics are distinctly different because they lag the development seen in more mature emerging markets.

According to John Wyn-Evans, Head of Investment Strategy for Investec Wealth & Investment UK, these differences include demographics, politics and policy, infrastructure and the composition of individual economies, among others.

“Some emerging market economies are built on exports, like South Africa and Brazil which sell their natural resources to the rest of the world. Conversely, China and India are mass consumption economies. As such, each emerging economy is affected differently by shifting commodity prices, as an example. For these reasons, viewing all emerging economies through the same investment lens will miss the nuances that can impact on investment returns.”

Stock selection in emerging markets

Wyn-Evans adds that investors who invest in stocks must also consider the disconnect that exists between economic growth and equity performance in emerging markets, which is largely predicated on the composition of the local index.

“There is a major disparity between the composition of indices in developed and emerging markets. For example, over a quarter of the developed markets’ indices are in high-growth sectors such as technology. Within emerging markets that figure is only about 16%, with the majority of these businesses focused on more cyclical and capital-intensive technologies such as semi-conductor manufacturers.”

Conversely, Wyn-Evans explains that returns from the financial sector have come under pressure of late. “This sector accounts for about 16% of global indices, but comprise over a quarter of indices in emerging markets. This composition makes a material difference between valuations and returns in both of those segments.”

Given the differences in composition, sector-specific opportunities exist between emerging and developed markets, he believes.

“These differences can make a difference in the way that these markets are viewed and how they are valued, which also offers long-term opportunities.”

 

This article originally appeared on Investec FOCUS.

 

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