Investing in the emerging markets has been rocked by geopolitical events and the ongoing effects of the Covid-19 pandemic. However, these fast-growing markets offer growth opportunities in the medium- to long-term and value in the short-term.
For an investor such as HESTA, investing in emerging markets offers higher returns over the longer term explained Jeff Brunton, head of portfolio management. “From a portfolio design element, our emerging markets exposure is driven by the higher returns in the longer term from a risk adjusted return basis,” he said.
“Our long-term strategic asset allocation uses long-term expectations of returns and risks across a range of asset classes including emerging market equities. These expectations have higher returns from emerging market equities than developed market equities due to factors such as population growth and a growing middle class.”
HESTA has A$68 billion of assets under management with 20 per cent of its international equities portfolio allocated to emerging markets investments.
Companies in north Asia, particularly China and Korea offer investors value for money with valuation at near rock bottom levels according to Rand Wrighton, fund manager of Barrow Hanley’s emerging market strategy.
“We are actually now starting to see a lot of value, particularly in China and also in Korea,” he said. “When you think about emerging markets over the long term, you typically have done well by buying really cheap assets with good long-term outlooks, we still believe the outlook long term in China is favourable.”
Part of Perpetual Asset Management International, Barrow Hanley currently has around US$700 million of assets under management in its emerging markets strategy.
Vulnerable to USD
An important consideration is that emerging markets are vulnerable to rising inflation and a strengthening US dollar.
“Inflation is a big worry as it affects the outlook for growth assets, particularly the US Federal Reserve’s reaction to inflation and whether it can engineer a soft landing,” said Adrian Hoe, senior consultant at Frontier.
Barrow Hanley’s Wrighton acknowledged the inflationary pressure on companies in emerging market economies but is confident of the long-term economic growth.
“As an investor if you have an 18-to-24 month time horizon, you can look at the individual businesses and think is it a good bet that they will ultimately be able to pass on the price increases and will their margins recover? And then, how is the valuation today relative to a recovery in in pricing and margins.”
Company valuations are sufficiently low enough to compensate for the short-term risk said Wrighton. “We’ve seen some real opportunity there, and, and a lot of these businesses, you know, there’s still very attractive long term consumption dynamics. The beauty about emerging markets is that you can buy businesses that have great long-term growth, but you don’t have to pay a premium multiple for one.”
Emerging markets have experienced much volatility, resulting in the MSCI Emerging Market Index falling. One of the factors contributing to softened index is the selldown of Chinese stocks, especially since China makes up a significant 35 per cent of the index, Frontier’s Hoe explained.
“The selloff in Chinese equities since late 2020 is driven by regulatory changes in the technology, education, gaming and property sectors and its zero Covid policy and related concerns around economic growth more recently,” he said.
Rising risks globally
Another factor hurting emerging market stocks is Russia’s war in Ukraine which has led to soaring energy prices and further disruption to global supply chains and food production.
“[The war] has caused a new focus on thinking about where risks and opportunities arise in emerging markets in portfolios,” said Hoe.
The spectre of a recession is also looming, making investors wary of taking on riskier assets. “Markets are forward looking and they are currently grappling with the risk of recession. If investors can see a point where economic fundamentals bottom and then there may be renewed interest in growth assets. However, I don’t think we are there yet,” he said.
Another key risk for Australian investors investing in emerging market equities is foreign exchange risk. Australian super fund investors tend to leave a portion of their international assets unhedged as a defensive strategy as a falling Australian dollar can provide an uplift in returns from the unhedged international portfolio.
HESTA has partially unhedged currency exposure in its international equities’ portfolio including emerging markets due to the diversified nature of the Australian dollar that tends to track the global economic environment said Brunton.
But he recognised the risks involved. “As we are typically overweight in emerging markets, we recognised the currency risk and the unintended consequences of a falling Australian dollar. We actively manage the forex risk to make sure the risk does not build and build.”