Emerging market investors have been battered by a decade of lackluster growth and uninspiring absolute returns. Now, as the trauma of Covid segues into the tragedy of war, we understand the temptation to fall back on linear extrapolation. But this would be a mistake: we contend that there is a lot for global emerging markets (EM) investors to be excited about.
This Time Is Different
Let’s begin by addressing the market’s current obsession with rising inflation and interest rates, and the perception that this must be a disastrous thing for EM. It’s a seductive theory; after all, every EM crisis in the last 40 years has been associated with a rising federal funds rate, a dramatic tightening of liquidity and massive capital outflows. On the other hand, there have been just as many occasions—the early 1970s, or the early 2000s, for example—when rising U.S. interest rates caused barely a ripple in EM.
Today’s reality is that many of the beneficiaries of inflation are in EM, including the energy and commodity producers, which have seen a marked upswing in fortunes this year. On the rates front, countries such as Brazil and Mexico pre-emptively increased interest rates long before their western counterparts, so have more room to maneuver. Similarly, China still has the luxury of positive real interest rates, allowing them to ease rather than tighten as growth slows.
Fine, but what about the golden age of globalization coming to an end? The verdict of many commentators is that EM—as the biggest prior beneficiaries of globalization—will be those most challenged by its reversal. This is a dangerous oversimplification, not to mention inconsistent with the arc of human progress.
Supply chains will continue to evolve, but there are still likely to be plenty of winners in EM even amid a reshuffling based on geographic and perhaps also political contiguity. Meanwhile, the largest economies will continue to look inward for growth. Self-sufficiency, billion-plus home markets, and growing evidence that homegrown companies can capture demand previously exploited by multinationals listed elsewhere will continue to provide stock-pickers with long-duration growth opportunities.
Net Zero: The New World Order
The energy transition is one area we are thinking hard about in the context of long-duration growth opportunities. We have been sympathetic to the arguments for upside surprises in the prices of several important commodities in recent years. What interests us far more than this, however, is the likelihood of an acceleration in the energy security and renewable agenda.
If we are to stand a chance of meeting this agenda, we will need a lot of stuff. Wind turbines, solar arrays, energy storage, electric vehicles and all of the associated infrastructure will not only require lots of steel and concrete, they will also require huge amounts of specialty metals and minerals such as lithium, copper, graphite, nickel, chromium and neodymium. And where are the largest, lowest-cost, most efficient and highest quality producers of this stuff? They are mostly in EM.
The energy transition may be as important an investment theme in the coming decades as Moore’s Law—the principle that computing processing power doubles every two years—has been in previous decades. What is striking is just how many of these beneficiaries are in EM—from the commodity producers and infrastructure providers that will build the new age, to the semiconductor companies, energy solutions providers and platforms that will power it.
Hitting The Demographic Sweet Spot
On a more macroeconomic level, advisors and investors should consider the demographics and dependency ratios in different countries. In countries where there is a high number of children or pensioners per adult of working age, savings tend to be minimal, capital is expensive relative to labor, and interest rates tend to be high, while investment tends to be low.
The higher the ratio of working adults to dependents, the better the banking system is equipped to fund investment needs. After all, a dependency ratio north of two is the sweet spot that North Asian economies, such as South Korea, have been in since the 1980s. It is exactly this sweet spot that many of the larger commodity economies in EM, such as Brazil or Indonesia, have only entered more recently.