Emerging markets - what's next

0:12Hello and welcome to the latest edition of the FTadvisor podcast. Today we are discussing the outlook and opportunities within emerging markets. I'm David Thorpe, Senior Investment Editor at FT Advisor. And joining me today are Loon Lim, Fund Manager at Ashoka White Oak Emerging Markets Investment Trust, Paul Niven, who, among other things, runs the FNC Investment Trust, and Peter Doherty, Head of Investment Research at Arbuthnot Latham. Good morning, all. Good morning. Good morning. Morning. Paul, if we start with you first, the emerging market index has returned around twice the level of the IA global sector over the past 12 months or so.

0:53What do you feel has driven this? Yeah, OK, so it's obviously been a very interesting period for global markets and for emerging markets. And year to date, we've certainly seen quite significant outperformance from EM, emerging markets, against developed market indices. I mean, in terms of IE sector and relative performance, I think what you're capturing in part is some of the relative performance that active managers have actually delivered. So global managers actually have had quite a tough time. I think in part, when one compares relative returns across those respective indices, that does explain some of the differential.

1:27But nonetheless, the last nine months or so has obviously been a far better period for emerging market performance, performing very strongly, about 30 % or thereabouts in dollar terms against 20 % if one looks at developed markets more broadly. And there's a few factors, I think, that have driven that strong performance and indeed the relative outperformance. It's clearly been a better environment from a macro standpoint for the EM complex. And that is despite what has obviously been quite a tricky period with respect to tariffs, tariff uncertainty. And there has been some perhaps relief in recent months from where we stood back in early April and concerns about overall tariff levels.

2:05But there's no doubt a number of bottom-up components and stories that are going to be discussed as we go through the next 20 minutes or so. But weak dollar clearly is a tailwind for emerging market performance. We do have expectations of quite significant rate cuts from the US Federal Reserve with the Fed starting their rate cutting cycle once again and the expectation of another four over the next 12 months. And again, that is constructive for risk appetite in general and for the emerging market complex. It's been a long-term story, certainly, but there's a significant value gap in terms of emerging markets against developed.

2:47And I think certainly people are looking, investors are looking for value opportunities against developed markets in the US in particular, which is looking pretty richly valued. So EM screen well there. And I think there's lots of self-help stories in emerging markets. There's far greater fiscal flexibility, arguably, in a number of areas, rate cuts also across the EM complex and elements like that that will help to drive and have helped to drive performance in EM. And also people have been under-invested, would be my view, so there's nothing to catch up here. Thank you. Peter, from your point of view, as a wealth manager, how have you been thinking about emerging markets?

3:29And has the outperformance over the past year or so surprised you? It's been very significant. And I think what surprised me more than anything is the shift in investor perceptions over EM. So if we were to rewind a year, I think the general perception was that China was sort of uninvestable for various reasons. declining property market, petrol deflation, poor profit growth, and trade concerns, numerous things. And the number of commentators I heard sort of completely blackballing Chinese exposure, and by extension, EM exposure, was quite startling. And what's happened over the last year is a number of those headwinds and factors have probably been reassessed by investing community.

4:22And the main driver of returns, if you look at the index or the global index, has been valuations. So valuations have expanded in emerging markets. So you're paying a higher level today than you were 12 months ago for the earnings. And when that happens, typically there's a change in perceptions and change of outlook. And so I think you have undergone this huge shift in the backdrop, which has led to the re-raising in EM assets. and it you know we can highlight a few of those we've already talked about the the fall in the dollar um uh which was exceptionally strong last year strong us and um sticky rates now uh falling rates and we had this moment earlier in the year with with deep seat which changed i think fundamentally investor perceptions of the potential competitiveness of of china within the the AI tech race.

5:14And so the way that we think about emerging markets more broadly is really on the growth differentials between emerging markets and developed markets. And emerging market growth expectations have been surprising to the upside. It was expected that post tariffs that they might suffer, but they have been very resilient and there's been a number of upgrades to growth expectations. So I think huge shifts driving valuation, re-rating, and then there'll be further questions for the future. But no, we've been relatively constructive on EM as a whole over the last year. Thank you. And Leung Lim, as the emerging market specialist around the table, have you been surprised by emerging market returns over the past year relative to the global index?

6:05and how have you been positioned or trying to capture those? Yeah, I would generally echo what's been said. I think we're fundamental bottom-up stock pickers, so we don't tend to have views on what's going to happen at a market level anytime soon. But fundamentally, if you break down what drives performance, it's usually driven by a combination of fundamentals and valuations. And like what's been said earlier, fundamentals are improving in emerging markets. So if you think about China, obviously the largest component of the EM index, yes, there have been a lot of headwinds. And like was mentioned earlier, it was seen as uninvestable maybe a year ago by a lot of the investment community, which clearly was not the right way to think about it.

6:50But China being such a large part of the index, we've seen a lot of industries actually start to bottom. So this is even before the government comes in with stimulus measures. We naturally saw a lot of industries starting to bottom and starting to rebound. So that's very helpful. The government taking an interest in the stock market also very, very helpful. But even beyond China, if you think about countries like Korea, the Korean market's done incredibly well. New president is more of a market-friendly president than the old one. So that's kind of hope that he would help there. And then also they've introduced their own value-up program.

7:24So if you think about the fundamentals, fundamentals have been improving quite significantly. So earnings growth increasing and actually growing quicker than developed markets. And then the other point that was also made here was valuation, which is the other big driver of performance. So valuation coming again from a very, very low base. So in terms of what's driven it, has it surprised us? It's not really surprised us because fundamentals have looked good, valuation has looked cheap. But in terms of the timing and maybe the strength of the rally, that's that kind of thing we always find hard to predict.

7:58But in terms of how we're positioned to try and capture it, I think we don't try to call particular markets or industries at particular times. So we try to run very diversified portfolios. We think that timing markets in EM is especially difficult. So going back to the point on China, you know, this time last year it was uninvestable, but a bit of stimulus and it ended the year as the best performing emerging market. So we think kind of broad exposure is what we should be looking for. Thank you. Paul, the F &T Investment Trust has been overweight to emerging markets, which kind of already answers the question I'm going to ask you, which is, can the performance continue?

8:42We've seen the benefit from dollar strength. All of you have mentioned valuations being cheap coming into the year, but obviously we've seen the index do well. Are valuations still attractive or have the earnings come true to justify the valuation? How confident are you that it will continue? I think one needs to obviously be humble when making predictions about the future, but we do remain constructive on emerging markets. we have added to positions in recent months. That's predicated upon the factors I outlined earlier. Essentially, as long as the global macro backdrop remains relatively supportive, the US recession is avoided, the developed and emerging market growth in general remains reasonable.

9:27Rate cuts in the US come through as expected. We're expecting very wide and broad rate cuts from within the emerging market complex, as I said earlier. We do expect some modest dollar weakness from here. And coming back to your question, we do think that there is still scope for that value gap relative to the developed areas to compress further. And we do feel that despite what has been quite a sharp turn in sentiment, again, as we've heard from China being viewed as uninvestable about a year ago through to more optimism certainly being evident in terms of surveys today, our sense is that the positioning is still relatively light.

10:09in this very long period of underperformance that emerging markets went through for more than a decade, clearly, is ripe to turn and to continue to see outperformance from that area, provided the macro backdrop remains relatively benign, as we expect. Thank you. Peter, given the strength of it, can it continue? And if it continues, what would be the drivers of that? I think over the last 15 years, we've seen very sporadic and short-lived outperformance of emerging markets in general, relative developed markets. And that's come with a backdrop of growth and earning superiority in the US in particular.

10:54And so if it is continue, while there might be a little bit more of a valuation catch up, I wouldn't expect sort of valuations to keep expanding without other factors to become more supportive. So, yeah, firstly, earnings, earnings relative to the developed markets and then also growth throughout markets, typically vital to emerging market performance, sustainability. and so you know can we make can we make a case for that well earnings have been somewhat somewhat muted somewhat modest but look to be turning around um the the growth backdrop does look conducive for emerging markets that you know the weak dollar narrative i'm sure we'll get onto the dollar and and and drivers of it uh stable economy but typically when you have when you have uh a very strong stock market and risk on appetite in equity markets.

11:54It feeds through to emerging market equities, emerging market FX to a good extent. So I think if this does stay intact, then you can see more of a rally, but you'll have to see those fundamental drivers, earnings and growth, really supporting continuation. and if we if we see any wobbles to that then then it would probably dissipate as it has done in the past the one thing i i'd sort of note is you know there does seem just very very recently to be a much higher level of correlation between some of the um stock market drivers say in the us around ai and those in emerging markets you have china which you know has very large component of tech You have Taiwan, I think about 20 % of the index, South Korea.

12:42And all these are tech and AI-related themes. And so it is, I think, also a little bit unpredictable as to how that narrow sort of market leadership of EM and markets in general might or might not broaden out. I think that's going to be a key question as well. Thank you for that, Peter. Luang, you mentioned you take a bottom-up and a stock-picking approach. Has the strong performance of the Merging Market Index over the past year reduced the opportunity set? Are there fewer attractive stocks out there for you to look at? No, I don't think so, actually. Given the improvement in fundamentals, I actually think we're seeing more opportunities.

13:33so to echo the earlier points it's a combination of valuation and fundamentals which in this case would be earnings growth and we're seeing you know both of those still being supportive but i would echo the last point made here which is i think what's slightly different um you know famous last words of course this time around though is that em and em we're actually seeing tech leadership so we're much more used to seeing tech leadership in western kind of developed market companies and emerging market companies kind of being the low-cost supplier or low-cost competitors that substitute products.

14:05But in places like electric vehicles or most of the hardware that's supporting the infrastructure build-out around AI, actually emerging market companies are the leaders. And so they're direct beneficiaries of a lot of the build-outs that's happening in those sectors. So I think there is still a lot of opportunity to look for and a lot of reasons to be optimistic in emerging markets. And Leung, if we stay with you for the next question, in terms of how you invest, how consequential is the outlook for the dollar? Yeah, so for us, this has always been a tricky one because we don't have a view on where the dollar is going to go.

14:44So for us, we think that, again, the best approach is to be very diversified. So what we're saying is that the EM universe is a lot more diverse than it used to be in terms of its makeup. So you have, I think, a lot of companies that do well in a stronger dollar environment. So companies like commodity companies, for example, so a lot of the LATAM names, but equally a lot of companies with dollar debt or companies with raw materials coming from the US or denominated in US dollars would struggle. So I think the point is that with the world being more global in nature, with supply chains being more global in nature, it's not so easy to pinpoint at a general index level whether the dollar is going to hurt or help fundamentals.

15:27Undoubtedly, I think the impact will be much greater on sentiment than it is fundamental. So you might see more of an impact in terms of flows and overall market moves. But in terms of the way we invest, the outlook of the dollar is not something that we spend too much time worrying about as long as we're comfortable with the risk exposure we have within our portfolio. Thank you. Peter, our boss, not Latham. how relevant is the dollar for you? I mean, even for UK-based wealth-managed clients, even their US equity exposure return has been dampened a bit this year by the weaker dollar. From an emerging market allocation point of view, is the dollar one of the things you have to think about?

16:11Yeah, we think about the dollar and we think about FX. We spend a lot of time thinking about it. And you've had a big shift in what's been driving dollar and currencies over the last year from interest rate differentials to probably a little bit more reflective of trade and trade dynamics. But and so for UK investors, the direction of the dollar relative to the pound is vital because we hold, you know, typically UK investors do hold a lot of global assets. And so when you have a weak dollar, typically that's a headwind to your returns. As it relates to emerging markets, so there has been a very strong correlation historically between the out and under performance of emerging markets and whether there's been a strong or weak dollar.

17:02So that exists. And it's very, very nuanced. You can make arguments for the causation of that, i.e. dollar weakening being good for EM, whether they have U.S. debt or it loosens financial conditions globally. But I think what's probably more reflective is going to be the relative growth dynamics between developed markets and emerging markets. And so if you have a very strong emerging market backdrop relative to developed markets and particularly relative to the US, you'd expect that to then be accompanied by a weak dollar strong non-dollar currencies and particularly if you continue to get this risk on environment.

17:44And so I think it will likely accompany one another, but I wouldn't say it is absolutely dependent. If you think about some of the drivers that have been mentioned already with regards to China, South Korea, Taiwan, tech, etc., this is not necessarily hinging on the US dollar. It's hinging on company fundamentals, which hopefully will lead to much better earnings potential within emerging markets. And already we can see that starting to come through. So if you look three years out, the expectations for EM in Asia earnings are improving relative to EM. And I think that's going to be a key driver ultimately of the dollar as well relative to EM.

18:27So it is important, but I'd say it's correlation. There is some causation there, but there's overriding factors that will probably be more important. Thank you. Paul, I think the point both of our other contributors have made really is that the fundamentals of emerging markets have improved and that that should mean the dollar is less consequential. But is it still the case that the impact of the dollar on sentiment towards emerging markets overrides everything else and overrides fundamentals? I certainly don't think that it overrides fundamentals. What I would say, and it's perhaps repeating some of the points made earlier on, which I agree with, is that essentially a weak dollar adds to the attractions of EM.

19:11I think there's several reasons why weakness in the dollar has historically proven to be beneficial for the relative performance of emerging markets in general. And, you know, again, as we've heard, there's some areas that actually benefit, you know, from specifically from weak dollar. But in general terms, many emerging market governments are borrowing in US dollars. And that weak dollar reduces debt burden, which reduces default risk, reduces repayment burden, tends to push commodity prices higher, tends also to be associated with the US Fed easing cycle, which in turn tends to be associated with, provided recession is avoided to the earlier point, decent risk appetite for investors, which in turn benefits from benefits emerging markets.

19:58So in general terms, it's not a deal breaker, but certainly a weak dollar, I think, does aid the case for investment in emerging markets, albeit at this point about what it implies in terms of sterling returns returns is obviously very significant and a point to be considered in terms of implementation. Thank you. And then, Peter, if we turn to diversification, what does diversification within an emerging markets allocation mean to you? How do you think about that when you're putting together a portfolio of emerging market assets? Yeah. So I think one of the key words that you used there was assets.

20:37And so, So firstly, I think within emerging markets, you have a lot of diversification within the asset type that you select, whether it be equities, local currency debt, so debt denominated in the EM, local currency, foreign exchange, hard currency debt, which is debt denominated in US dollars, and the overall FX complex. And so you can think about it from both the asset selection perspective and then the country diversification. Within emerging markets, there's just huge country diversification. That's great because you're not taking a bet on one individual company or sorry, country where you can have default and lots of economic problems.

21:26See Russia, Turkey, Argentina. And so with that brings a lot of different drivers for the economy, for the FX, for the equity markets. And so lots of different stories coming up through that. And that's one of the key benefits, I think, of emerging markets. One of the key areas of diversification that you have people talking about today is diversification away from the U.S. dollar. And what's become quite popular recently is looking towards emerging market foreign exchange as the key beneficiary, as a lot of these emerging markets have high real rates. It looks like they're going to cut interest rates.

22:07They've already started easing. And so pivoting away from dollar and dollar assets, what can you go to? You can go to a variety of assets with tailwinds all connected to the US dollar sort of falling. And that gives a great level of diversification potentially within a multi-asset portfolio. The one thing I'd sort of say within emerging markets, again, just reiterate, is this AI-driven factor, which has started that correlation to U.S. tech, means that I think when you're putting together your EM portfolio, you have to be very conscious of that. If you have a lot in AI tech in the US and you're building up EM in AI tech exporting nations, which dominate about 70 % of tech exports, then you might not have that diversification that you were first seeking.

23:00You know, if the AI party stops, then you might find weaknesses connected to emerging markets. Thank you for that. Paul, within the allocation that you've got within the F &C Investment Trust, how do you think about it? Is diversification, again, local currency versus hard currency, tech versus non-tech, or is it geographically based? Yeah, so for F &C, we're in a whole range of mandates, Clay, in terms of the multi-asset space. But for F &C, we're focused very much on equities and private equity. And within the equity space, we've got mandates which are run by the teams within Columbia through a needle.

23:38And the exposure they get there to emerging markets is through several global mandates, which are focused either on an income with an income lens, a growth lens. And then we've got an external mandate that we granted actually back in February to Invesco, who run a separate account for us in EM. So we've got diversification in terms of the stylistic composition of those underlying exposures, albeit I would say that from a factor perspective, I mean, we think that one does get rewarded for a certain factor exposure through time. and in emerging markets, focus on quality and value in general, does tend to have a positive payoff.

24:21So stylistically, our exposure tends to be aligned to that type of approach, which has historically worked well and I think is also conducive to strong returns going forward. I'll make a couple of additional points. I think this point about concentration, diversification is a challenge. despite all of the idiosyncratic opportunities and all the geographic and sectoral opportunities one has in EM. It is also an issue if one looks at the indices in EM as it is in DM, where obviously the US and tech is dominant in the developed space in emerging markets. It's not quite the same story, but the top 10 stocks account for about a third of the overall index.

25:05And there's a lot of concentration in terms of geographic exposure, obviously, with China, India, Taiwan, and South Korea, constituting the significant majority, about 75 % of the overall exposure in emerging markets. And then from a sector perspective, financials and IT accounts for about half the exposure of emerging market indices. So I think there's certainly a case to look beyond the indices, as there is in DiEM, which are relatively actually concentrated towards the many opportunities that do exist within that complex. And again, the way that we achieve that is through a small number of mandates, some of which are specialist in the emerging market space and some of which give us exposure through the global lens.

25:54thank you uh thank you for that paul and uh uh for you loong how do you how do you uh think about uh diversification within your emerging markets fund um so pure we run a pure equity fund so um you know i'll stick to that asset class and i love the points that were made before because i think one of the keys is that diversification is kind of thinking about it at a country level but also at a sector level. So beyond the big names like China, Korea, Taiwan, India, actually, in the last couple of maybe the last decade or so, a lot of the smaller markets have actually become a lot deeper. And there are a lot more opportunities.

26:34So Southeast Asia, for example, really benefiting from the China plus one story, you're seeing a lot of investment going there, the Middle East trying very hard to diversify away from oil and gas. So that's also creating opportunities in the private sector. But beyond that, I think the other key to remember, rather than just diversifying at a country level, is understanding the exposure that you're getting. So let's say, for example, you wanted to invest in India, but you only bought the IT service companies. Those are very much linked to developed market economies. You'd probably want exposure to other sectors there.

27:08And maybe the final point to add on is the efficiency of emerging markets tends to be a lot lower, especially in that small mid-cap space. And then, as we know, the beauty of a trust structure is that it gives you the, I guess, the liquidity profile that you can invest in a lot of these small mid-caps. So I think it's country, but then also within the country, the sectors, and then also looking at maybe less efficient products of the market to get some idiosyncratic risk. Thank you for that, Luen. And that's about all we have time for. I think there's some interesting points made there around the changing nature of the composition of the emerging market index with with tech being a much more relevant sector than perhaps it was in the past.

27:55In the past, investors really thought about emerging markets as being about commodities. and maybe there is an element of the consumer and demographics but as was referenced technology companies that are becoming almost as well known as those in some of the developed markets have become a significant part of the index and so with that i'd like to thank lung lim fund manager of the ashoka white oaks emerging markets investment trust paul niven who runs the fnc investment trust and other mandates at columbia thread needle and peter doherty head of investment research at arbust not latham and thank you all for listening please do remember to tune in to future editions of the ft advisor podcast thank you

28:58Thank you.