Art by Klaus Kremmerz
The past few years have been rough for emerging markets investors and downright bad for frontier market investors. Market volatility, geopolitical concerns, tight liquidity and changes in the benchmark indexes have made it difficult for investors to find places that feel solid enough to invest.
Money managers investing in these markets have pointed to a few pockets of opportunity, but investors will have to be wary, as it may be difficult to exit quickly if conditions change.
According to a recent analysis from emerging markets investor Gramercy, global economic activity held up relatively well in the second quarter of the year. Purchasing Managers Index strength in emerging markets and developed markets is pointing to a global growth rate of 2.8% for the first half of 2023. GDP growth in emerging markets is also starting to catch up, and Gramercy predicted this trend will continue into the third quarter. Inflation, too, has remained lower than analyst estimates. These positive trend lines could help markets that rely on emerging and developed markets to purchase their goods and services.
The China Effect
A big piece of the puzzle, however, will be China. Gramercy noted that the economic data out of China in the first half of the year remain soft, and fiscal stimulus is likely forthcoming in the back half of the year.
If that happens, it could be a positive for key markets like Vietnam, says Luke Barrs, head of fundamental equity client portfolio management at Goldman Sachs Asset Management.
“China is trying to domesticate its growth so that more of it comes from consumers and less of it comes from government spending,” he explains. “As that happens, it could be a positive for [Association of Southeast Nations] countries that ship into China, because it is their closest large consumer market, or [that] are part of a China-plus-one supply chain strategy, but that’s going to take some time, and much of it depends on a rebound within the Chinese economy.”
ASEAN countries, including the Philippines, Indonesia, Malaysia, Thailand and Vietnam, have been playing a bigger role in the global supply chain, which has boosted their economic prospects, but Barrs points out that there are still numerous hurdles for investors in these countries: They have small economies, with few listed companies, and liquidity is lower, which can make it challenging to exit positions quickly.
These countries can also be prone to big price swings as investor interest ebbs and flows. Barrs says Vietnam is one key example. Vietnam has a large handful of high-quality, listed companies, which makes it attractive to investors. Yet it is still a relatively small market, so the opportunity can be limited. “We are positive on a few consumer companies in Vietnam, for example, but they are getting expensive now, in part because of growing investor interest,” he says.Index Changes Come With Trade-Offs
China is not just playing a big role in the economic prospects of ASEAN countries; it also has a big influence on emerging and frontier market indices that investors track for their global allocations. China accounts for 30% of the MSCI Emerging Markets Index, and when its companies drag, they take the entire index with it. For comparison, the MSCI Emerging Markets ex-China Index was up 12% for the year through June 30, compared to the MSCI Emerging Markets Index, up just 1.75% over the same period.
Trends like that can be problematic for countries like Vietnam, which currently makes up 30% of the frontier markets index. If the country eventually moves into the emerging markets index, it goes from being a big, investible fish in a small pond to a medium-sized fish trying to compete in a much larger body of water. If countries like Vietnam left the frontier markets index, it might also make it more difficult for investors to use that index reliably, because it would have fewer anchor constituents that have multiple listed companies.
Some money managers appear to already be doing that math. As of June 1, iShares converted its $707 million MSCI Frontier and Select EM ETF to active management, dropping the peg to the MSCI indices and dropping the MSCI name from the title. According to BlackRock, the shift to active management should give the fund greater flexibility to respond to shifting market conditions.
“We think the jury is still out on whether the frontier market index is a viable index,” says James Donald, managing director and head of emerging markets at Lazard Asset Management, which invests in frontier markets through select actively managed strategies. “It’s challenging to take a broad brush to frontier markets—these countries have a lot of limitations, which is evident in how frequently index constituents come under review.”
Donald notes that Nigeria, another frontier market, has several interesting investment themes but is under review because of geopolitical shifts in the country that make it a difficult place to invest. There is a possibility of Nigeria moving to its own index, which could make it more challenging for investors to track. “Nigeria reminds me a lot of Brazil 25 years ago,” says Donald. “There are a lot of interesting trends there from an investment perspective, but there are a lot of limits.”Diligence Still Required
Both Barrs and Donald are broadly constructive on emerging markets and some pockets of frontier markets. But both are quick to point out that the indexes often do not tell the whole story.
Barrs is positive on parts of Eastern Europe, given recent efforts by countries like Slovenia and Romania to move toward sustainable energy sources. Persian Gulf countries, too, he says, have relatively broad consumer markets and are working on removing some investor limitations, which is a positive trend over the long term.
“Current valuations in emerging markets and some frontier markets are very attractive,” Barrs says. “That’s driving some investor interest, but in market conditions like these, investors have to be diligent. Many of the core challenges, like low liquidity, still remain. You have to be willing to look company by company.”
Tags: ASEAN countries, China, Goldman Sachs Asset Management, Indonesia, Malaysia, Persian Gulf, Philippines, Romania, Slovenia, Special Coverage: Emerging Markets, Thailand, Vietnam