By Philip Shucksmith, portfolio manager BNY Real Return Fund.
When navigating markets, we consider three main factors: the structural drivers, the cyclical drivers, and the valuation. Considering each of these factors in turn we conclude that we are at an interesting juncture for emerging market assets.
The structural drivers for several key emerging economies are reasonably well understood. Favorable demographic profiles with the potential for strong labor force growth support the potential for growth in domestic consumption. The stage of development for India, in particular, puts it at an inflection point of infrastructure build-out akin to China 30 years ago, and this is happening at a time when climate-change mitigation and adaptation investment globally is starting to drive a fresh wave of commodity demand, benefitting countries such as Indonesia, Peru and Brazil, which are rich in energy-transition minerals.
The cyclical drivers are, however, equally if not more important for investors to consider, because the well-rehearsed structural bull case for emerging-market assets can be undermined for protracted periods of time by cyclical factors. The past decade of zero interest rates created a very narrow focus on a thin layer of internet stocks and financial engineering instead of real capex. It also coincided with a period of US dollar strength which came to a head in 2022, which put significant pressure on the offshore US dollar system.
Today we see evidence of cyclical factors turning more in the favour of some emerging markets. Countries such as Mexico, Brazil, Indonesia, and India arguably navigated the Covid pandemic better than many Western economies, resulting in fewer lingering inflationary imbalances, less fiscal interference, and the associated government debt burden. This allowed them to raise interest rates early to combat inflation. Today central banks such as Mexico’s are in a position to start cutting interest rates and stimulating the economy at a time when most developed-market central banks are still on the back foot fighting inflation, and we expect the extreme period of US dollar strength to start to reverse.
Valuation alone is not a recipe for strong returns; however, we believe we are starting from a point of relatively undemanding valuations for many EM assets when considered in absolute terms and certainly relative to many developed market assets. This has transpired through a torrid few years of de-rating and underperformance.
We are currently expressing our constructive view on emerging market assets in four ways: direct equity exposure, indirect equity exposure, local government debt, and currencies. We like emerging-market financials to obtain a geared exposure to domestic development. HDFC bank in India, for example, provides a warrant on India’s fast-growing economy, while trading on a reasonable valuation. For indirect equity exposure, we like the western-listed consumer staples such as Unilever which derives more than 50% of its sales from emerging markets.
On the emerging-market government bond side, there is a group of nations that are now less reliant on USD funding, having developed relatively deep and liquid local-currency government bond markets. Mexico, Brazil, and Indonesia are three examples of bond markets that we currently own. We expect interest rates and bond yields to come down before many developed markets. On the currency front, we like the Mexican Peso and the Brazilian Real relative to the US dollar.
