Will EM continue to show promise?

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April 30, 2021

 

As US inflation began to come into greater focus in February, market participants reacted, leading to volatility in emerging markets. Additionally, the reflation trade resulted in a rotation from growth to value, according to the BNY Mellon Global Emerging Markets team.

While there have been market fluctuations, the long-term opportunity in emerging markets remains unchanged. High levels of income growth, increased product penetration and room for industry consolidation could mean the best is yet to come for the asset class, according to the team.

“We believe there is a unique opportunity for emerging-market companies that are well exposed to reliable secular-growth trends. Particularly those that can exploit this opportunity in a superior manner to their peers by virtue of differentiated customer offerings and execution,” the team says.

“Despite challenges like aging demographics and high global debt levels, we’re seeing exciting innovation and change, and pockets of sustainably fast economic growth.”

However, what started as a powerful year for emerging markets has somewhat fizzled out. China, which posted positive Gross Domestic Product (GDP) gains of 2.3% in 2020, one of the only major economies to expand last year, weighed the asset class down during Q1. This was partially because it fared better than others last year, making it less of a reopening play, according to BNY Mellon Global Emerging Markets manager Ian Smith.

He adds that China’s other points of weakness can be attributed to less stimulative monetary policy, worries about regulation in certain sectors, and turbulent relations between it and the US.

But—even with near-term headwinds—China still offers opportunities at the individual security level. During the first quarter, the team established a position in a leading supplier of electricity hardware and software to the Chinese state grid.

“The company is structurally well positioned to benefit from growing investment in ultra-high voltage (UHV) transmission, electric-vehicle charging and digitisation of the electrical grid,” the team says. “The stock currently generates mid-teens returns, but this should grow as the company’s product mix becomes more software-focused, and as China increases expenditure on its grid.”

Elsewhere, India’s economy climbed out of a recession posting an annual growth of 0.4% in the fourth quarter of 2020. It’s there where the team found another opportunity to add to its portfolio.

This came in the form of a “well-managed, capital-light, high-quality” Indian IT (information technology) company. It’s the second largest company in India by market capitalization, and one of the largest IT companies in the world, with annual revenues in excess of US$22bn. Relative to the broad technology universe, it has delivered top quartile returns on invested capital, according to the team.

“The company benefits from thematic growth, driven increasingly by digital transformation, and by facilitating its clients’ moves to cloud-based infrastructure. A further attraction of the business is that it’s highly cash-generative and is expected to return over 90% of its free cash flow to shareholders via dividends and share buybacks,” the team says.

Both the new Chinese and Indian holdings are in the information technology sector, in which the team had a 27.17% weighting compared to the MSCI Emerging Market index’s 20.92% at quarter end.1

Outlook

Asset prices, including those in emerging markets, could be vulnerable if inflationary pressures in the US become more acute, according to the team. They add that emerging markets would likely fare better if inflation is more benign, particularly if it is consistent with a promising global economic rebound. Other supportive factors would be if a weakened US dollar remains the status quo and accommodative monetary and fiscal policies continue.

“We are conscious that these variables can influence outcomes, both positively and negatively, for emerging markets in the months ahead,” the team says. “However, our focus is longer term and we remain excited about reliable and large-scale compounding opportunities in the countries where we invest,” they conclude.

1 Figures as of March 31, 2021.

 

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