The asset management house lays out where it is positioning in emerging and frontier markets.
In this question and answer session, William Palmer and Michael Levy, co-heads for emerging and frontier equities at Barings, discuss their approach to accessing the asset class, current trends, and why recent headwinds may be becoming tailwinds. The editors of this publication are pleased to share these insights. For feedback, email the editor: email@example.com
EM equities have started 2019 positively after a challenging end to last year. How is the asset class now positioned for investors?
Michael: The correction in equity markets last year reflected investor concerns regarding the US Federal Reserve’s tightening, and the potential implications for EM countries, especially those with current account deficits. In addition, rising trade tensions between the US and China also contributed, raising questions on global growth. In our opinion, these two factors led investors to demand a higher risk premium for investing in EM equities.
William: We note that the risks associated with these events have fallen in the last few months. Firstly, the Federal Reserve has become much more dovish in response to more mixed economic data in the US. Secondly, there has been significant progress in the trade discussions between the US and China. The reversal of these former headwinds into potential tailwinds has been a significant driver of markets so far this year.
Michael: As economic activity slowly improves, corporate earnings should also follow. This is likely to provide further support for equity prices as confirmation of this earnings improvement materializes.
William: It’s also worth noting that investor expectations remain depressed as reflected in the modest consensus forecast earnings growth for 2019 and attractive relative valuation versus MSCI world equities on both a P/E and P/B basis. This low bar gives considerable potential to positively surprise over the course of this year, while current valuations provide an attractive entry point for investors to build a strategic position in emerging market equities.
Which equity markets in EM do you prefer?
William: As bottom-up managers, we don’t engage in top-down country selection. We want to look across the whole investment universe in order to identify the most attractive opportunities and build a well-diversified investment portfolio. Clearly macro risk cannot be ignored, so we aim to capture this in our analysis through the cost of equity we set for each individual company. China remains a country where we continue to find a wealth of exciting investment opportunities, especially in areas such as technology and insurance.
What are the potential risks and opportunities if the US/China trade talks don’t reach a swift resolution?
Michael: We observe the substantial progress on trade talks between China and the US over the past few months. In recognition that a trade war is damaging to all economies and financial markets, both sides appear willing to reach a satisfactory resolution on key areas such as the bi-lateral deficit, intellectual property protection and market access. Confirmation of such an agreement would clearly lift investor, corporate and consumer confidence in China and across emerging markets.
William: Rising protectionism naturally leads to greater uncertainty. If there is not a relatively swift resolution, it may lead to slower global growth in the near term, but over the medium term, growth is likely to revert back to more normalised levels. Policymakers are well aware of the downside risks from the trade tensions, which is why China has announced fiscal easing measures amounting to 1.5 per cent–2 per cent of GDP. This should support economic activity and corporate profit growth as we progress through 2019 and beyond.
What long-term growth opportunities do you see in EM?
William: Whilst the EM middle class is rapidly growing, it is crucial to look much deeper and understand the changing demographic in order to identify what this segment is likely to consume going forward. We see huge opportunities in areas such as financial services, particularly pensions, life insurance and more sophisticated financial savings products which create opportunities for equity investors in the insurance and banking sectors. We also see opportunities in private healthcare, private education and across the technology space, including hardware, software, social media and e-commerce.
Michael: On that point regarding e-commerce and the internet, the internet has clearly gained significant adoption in EM, and, there are a variety of unique investment opportunities within emerging market countries. For example, as Russia’s digital economy matures and consumer behaviour and spending patterns shift, its domestic service providers are rapidly growing advertising revenue, e-commerce revenue and capitalizing on new revenue opportunities in the sharing economy.
William: Also, we aren’t ignoring opportunities in traditional areas of the economy; for example, there are some incredibly well-managed companies in the resources sector that are generating impressive cash flow, even based on conservative resource price assumptions. This is important because as a bottom-up manager, we don’t want to have a narrow focus. We want to look across the whole investment universe in order to identify the most attractive investment opportunities and build a robust and diversified investment portfolio.
What’s the best method of accessing the EM opportunity: active or passive investing?
William: We strongly believe in active investing because emerging markets are naturally very inefficient, particularly as a result of low analyst coverage compared with their developed market peers, and also high retail investor participation. The wealth management industry hasn’t yet developed to the same extent as in the West and, as a result, people invest directly into shares as opposed to mutual funds. The Chinese market is a good example, where retail investor participation accounts for more than 80 per cent of daily market turnover, according to the World Bank. This can lead to a lot of share price overreaction, to both positive and negative news and create inefficiencies which can be captured by applying a fundamental, bottom-up process.
Michael: Passive investing by nature anchors investors to a specific benchmark. In our view, the main benchmark, the MSCI Emerging Markets Index, is not a true representation of the opportunity set in EM, and we consistently find sources of alpha in companies outside the benchmark. Another development in recent years is a change in regulation through MIFID II. Sell-side company research in emerging markets has declined significantly due to a reduction in analyst coverage of equity stocks in EM, which creates further inefficiency that an active manager can exploit, particularly over a medium to long-term horizon such as the five-year research horizon we use at Barings.
How is Barings’ investment process different from other EM managers?
William: As a bottom-up manager, we focus on fundamental company research, but we also aim to capture macro risks through our cost of equity calculation, differentiating the risk environment in each country. Consequently, we’re able to assess total risk for each company in our portfolio. This essentially helps ensure that we reflect currency risk when investing in EM, which can have a significant impact - positive or negative - on the investment return to clients. For instance, in a high inflation country such as Turkey, quite a lot of your local currency return can be eroded by currency depreciation when it’s translated back into US dollars, so we would require a much higher expected return before we invest to compensate for the higher risk.
Michael: We also have added fully-integrated Environmental, Social and Governance (ESG) analysis into our process by ensuring that a company’s ESG score automatically impacts the cost of equity, or required return. Industry-leading ESG practices can support a positive assessment, while poor management attitude towards ESG, or worrying environmental or social issues, is sufficient to downgrade an assessment to such an extent that investing in the company becomes unattractive.
Any final thoughts?
William: Over the long run, we believe corporate earnings should drive equity prices. Given that long-term economic growth is higher in emerging markets versus developed markets, it seems sensible for investors to have exposure in this asset class. As emerging markets introduce more orthodox policymaking and embrace economic reforms, this should lead to more sustainable economic growth, which should be reflected into asset prices over time.
Barings is a $317-plus billion (as of 31 March, 2019) global financial services firm and is a subsidiary of MassMutual.