The Point

Emerging markets: Look past commodity exports to countries with strong domestic demand

Emerging markets investors often focus on commodity-intensive countries – many of which rely on China as one of the world’s top importers.

That may not be an attractive angle right now due to China’s weaker economy.

But it doesn’t mean there isn’t opportunity in the EM space, says Pendal PM James Syme.

Look past commodity export data to identify strong domestic demand stories, says James.

He points to Latin America, where GDP growth and equity market returns are traditionally correlated with commodity prices – especially metals.

“We’re very positive on the outlook for the domestic economies of Brazil and Mexico,” says James. “But not because we’ve got a particularly positive view on metals.”

Both countries should see significant interest rate cuts this year and next, further stimulating what is already quite robust domestic demand.

Capital inflows and caipirinhas: Brazil’s sunny outlook

Brazil’s central bank, Banco Central do Brasil, was one of the first global monetary authorities to start lifting interest rates.

It was tough medicine but now the top-ten economy is reaping rewards earlier than its peers, says James Syme, who co-manages Pendal Global Emerging Markets Opportunities fund.

“In emerging markets, typically everything goes wrong, or everything goes right.

“If things go right, you typically get capital inflows, a stronger currency, a better inflation outlook, the prospect for yields to fall, equities going up along with economic growth – and an easing of any political stresses.

“We think that’s where Brazil is now.

“We are also seeing broadly similar patterns in India, Indonesia and Mexico.

“Long, deep down-swings tend to be followed by long upswings – and that’s broadly what we expect will happen with these economies.”

Emerging markets aren’t so different to us – but you’ve got to pick the right ones

There’s a common misconception that emerging markets countries are dysfunctional, war-torn or burdened with significant health or security issues.

“But they’re not that different from us,” says James Syme, who co-manages Pendal Emerging Markets Opportunities fund.

“The main emerging market benchmark has 24 countries in Latin America, eastern and southern Europe, Africa and Asia.

“Generally they are well-run democracies or stable non-democracies with happy, successful economies and large and growing middle classes.”

That misperception presents an opportunity, says James – as long as investors can choose the right countries.

James and his team are now investing in eight EM countries including Brazil, Mexico and Indonesia.

EMs can help diversify risk in global equities portfolios, says James.

Why advanced economies such as South Korea are classed as emerging markets

SOUTH Korea is one of the few countries in the world to develop its own supersonic jet fighter.

It’s a stable and mature democracy — and home to some world-leading technology companies.

So some investors might be surprised to find it’s classed as an emerging market, along with Taiwan and  wealthy Gulf countries such as Saudi Arabia and the United Arab Emirates.

What is an emerging market? Who decides the definition of emerging equity markets?

It’s an enduring controversy. Some countries at the more advanced end of the emerging markets (EM) spectrum could arguably be classified as developed markets.

It’s useful for investors to understand how countries are classified as emerging markets as opposed to frontier (or pre-emerging markets) and developed markets.

Emerging Markets: Why some investors may benefit more than others as the tide turns

HIGHER US rates and a US dollar have recently curbed Emerging Markets returns, since they tend to depreciate other currencies, weaken US demand and draw capital out of EM economies.

As inflation comes under control, it’s expected that rate rises will decelerate and the US dollar will eventually weaken.

That’s good news for EM investors.

But there is another change that may benefit some emerging markets investors more than others: country-level factors are again becoming a powerful indicator of potential returns.

Investment managers that focus on top-down, country-level analysis should be able to take greater advantage of the changing conditions.

Signs of improvement for two big factors that drive Emerging Markets

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

The end of the US rate cycle is starting to come into view and a newly engaged China is beginning the process of restoring growth, says James, who co-manages Pendal Global Emerging markets Opportunities fund.

That leaves it increasingly likely that stronger returns from EM stocks are imminent, he says.

“The two big drivers of the difficult environment in emerging markets in the last 21 months all seem to be improving,” says James.

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