Signs of improvement for two big factors that drive Emerging Markets

A turning point for emerging markets may be approaching as the drivers of recent weakness dissipate, argues Pendal’s James Syme.

• US dollar outlook key to EM
• China emerges from downturn
• Find out about Pendal Global Emerging Markets Opportunities fund

A TURNING point for emerging markets equities is approaching as the drivers of recent weakness rapidly dissipate, says Pendal’s James Syme.

Emerging markets equities have faced headwinds in an environment of rising rates, a higher US dollar and China’s economic troubles and restrictive government policies.

But with the end of the US rate cycle starting to come into view and a newly engaged China starting a process of restoring growth, it is increasingly likely that stronger returns from emerging markets stocks are imminent.

“The two big drivers of the difficult environment in emerging markets in the past 21 months all seem to be improving,” says Syme, who co-manages Pendal’s Global Emerging Markets Opportunities fund.

“And that’s coming at a time of year when emerging markets have historically performed well.”

There is a long-established relationship between the performance of emerging markets equities and the US dollar.

“Since emerging markets came into existence as an asset class in the 1980s, virtually all the money that has been made has been during periods of dollar weakness, says Syme.

“Return on equity in strong-dollar periods is somewhere around zero.”

How the USD affects emerging markets

There are a few reasons for this relationship.

First, emerging market countries tend depend on external financing to grow their economies.

Some use external financing to build manufacturing export capacity — Japan, Hong Kong, Korea and Taiwan all took this route. Others export commodities — like Saudi Arabia, Brazil or South Africa.

“Either way, external flows of capital — bond investors, equity investors or foreign direct investment — is a huge driver of what happens,” says Syme.

“Exchange rates are just ratios. When someone is selling dollars, they are buying something else.

“Are we into a weak dollar environment yet? No. And it’s premature to call it with US inflation still at 7.7 per cent.

“But when we do get to the point of a weaker dollar, the implications will be very powerful. You will want to own emerging markets when we get there.”

China’s impact on EMs

The other big driver of emerging markets opportunity is China.

This is partly because it is the largest part of the asset class, accounting for about a third of value in the emerging markets index.

“It has the most number of companies in the index so what happens in China drives returns for the emerging markets asset class as a whole,” says Syme.

“But it is also a tremendous consumer of raw materials and manufacturing products.

“In the last 20 years, emerging markets as a whole do better when China is strong and accelerating.”

But what’s the right way to play the opportunity in emerging markets over the coming year?

“It’s too simplistic to just go and buy back beaten down tech holdings like Alibaba and TSMC that were the leaders of the last bull market. Maybe they will do well – but you can’t just assume.

“The world has moved on. We’ve seen Armageddon in the crypto space, a lot of pain in VC-funded start-ups and significant cutbacks in the global mega tech players. That includes China.

Syme says instead the drivers of the next leg of growth will more likely be old world companies like Anhui Conch Cement, Tsingtao Brewery and Hong Kong Exchanges and Clearing.

But he says the key for most investors is simply to review their portfolios and ensure their emerging markets weighting has not been thrown out by the recent declines.

“Right now, you don’t want to be too underweight EM and you don’t want to be too underweight China.”

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About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here